Chapter 2, Problem 14PROB

Summary Introduction

Calculation of P/E ratio and M/B ratio. IIS has $35 million of common equity, $14 million of net income, and 7 million shares of common shares outstanding. The market price of the common stock is $8 per share.

The price to earnings ratio (P/E ratio) is the ratio of firm's current market price and earnings per share. It gives an idea about the dollar amount an investor can invest in the firm in order to earn one dollar of that firm's earnings.

$P/E\text{ ratio}=\frac{\text{Market price per share}\left(MPS\right)}{\text{Earnings per share}\left(EPS\right)}$

Earnings per share (EPS) is the firm's profit earned for each share. It is calculated by dividing the firm's total profit with total number of outstanding shares.

$EPS=\frac{\text{Net income}}{\text{Number of outstanding shares}}$

Market to book ratio (M/B ratio) is the ratio which shows the relationship between the book value of the stock in the balance sheet and an actual market price of the stock. It helps to measure how much investors are paying against each dollar of book value of the stock in the balance sheet.

$M/B\text{ ratio}=\frac{\text{Market price per share}\left(MPS\right)}{\text{Book value per share}}$

Book value per share is the value which measures the firm's net asset value on a per share basis.

$\text{Book value per share}=\frac{\text{Total equity}}{\text{Number of outstanding shares}}$