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CHAPTER 4

Companies also have what are called “diluted earnings per share.” These are computed by dividing the available income to com- mon shareholders by the number of outstanding shares of common stock plus any shares that would be outstanding if any employee stock options or stock awards outstanding, convertible securities and warrants were considered (dilutive potential common shares). In some cases, the difference between the basic EPS and the dilutive EPS is great, solely because of the number of dilutive potential com- mon shares. Note the difference in the earnings per share in our example when dilutive potential common shares are considered. EPS drops from \$4/share to \$3.20/share.

\$5.8 m î€‚ \$1 m =

\$4.8 m

= \$3.20/share

1.2 m s + .3 m s = 1.5 m shares

Analysts usually place a lot of emphasis on earnings per share. It’s important to note that when they discuss EPS, they generally are referring to the diluted earnings per share. They also cite the EPS when discussing the trend for certain companies. However, we can say that the share price will keep up with the earnings per share, either rising or falling. In the past few years, we’ve seen more of a disregard for EPS when it came to new issues and hot dot.com stocks, which was due, in part, to the fact that these companies had no earnings. But with the market downturn, we’ve returned to using the EPS as an indicator of how a company is doing.

Price-Earnings Ratio The price-earnings ratio (P/E ratio) for a common stock is found by dividing the share price of the stock by the current earnings per share. Therefore, from our previous example, XYZ’s EPS was \$4 per share. If their stock price was \$55 per share, their P/E ratio would be 13.75 (\$55/\$4).

The P/E ratio is also a highly respected method of measuring a stock’s value. Generally, the lower the P/E ratio, the better the stock buy. However, a high P/E ratio is all right if the company’s earnings are expected to grow. When evaluating a stock, it’s a good idea to look at the historical P/E ratio data. Looking at the trends for a par-

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