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You are considering investing in one of two companies. Company A has earning per share of $5 and...

Question:

You are considering investing in one of two companies. Company A has earning per share of $5 and a market price of $40. Company B has earnings per share of $12 and a market price of $120.

1. Based on that information alone, which company should you invest in? Explain your answer, including what ratio you used to inform your investment decision.

2. Do you think that you have reviewed sufficient information to make your decision? What other information or ratios would be helpful in deciding which company to invest in?

What Is The Earnings Per Share:

A company's Earnings Per Share is used by investor to value its stock (through the Price/Earnings ratio). The Earnings Per Share reflects the net income earned during the period that is attributable to every single common share outstanding.

Answer and Explanation:

1.

We will use the price/earnings ratio in order to value these companies.

Price/Earnings = Market price / Earnings per share

Company A: 40 /5

= 8 times

Company B: 120/12

= 10 times

I would invest in Company A because the price earnings ratio is lower, which means that it is valued more cheaply and thus offers a better investment opportunity.

2.

No, certainly not.

  • We would need to consider why there is a difference is price/earnings ratio (maybe Company B just signed a major contract that will double its revenue and it's not yet baked into the earnings per share). I would thus consider the latest news, the liquidity and profitability ratios of each company.

Learn more about this topic:

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How to Calculate Earnings Per Share: Definition & Formula

from Introduction to Business: Homework Help Resource

Chapter 24 / Lesson 14
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