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options and convertible securities, a second EPS is calculated by public corporations, which is called the diluted EPS. This lower EPS takes into account the effects on EPS that 52

    I N T E R P R E T I N G F I N A N C I A L S T A T E M E N T S
    would be caused by the issue of additional common stock shares under terms of management stock option plans and convertible securities (plus any other commitments a business has entered into that requires it to issue additional stock shares in the future). Both basic EPS and diluted EPS (if applicable) are reported in the income statements of publicly owned business corporations. The diluted EPS is a more conservative figure on which to base market value.
    MARKET VALUE RATIOS
    The capital stock shares of more than 10,000 business corporations are traded on public markets—the New York Stock Exchange, Nasdaq, and other stock exchanges. The day-to-day market price changes of these shares receive a great deal of attention, to say the least. More than any other factor, the market value of capital stock shares depends on the earnings per share performance of a business—its past performance and its future profit potential. It’s difficult to prove whether basic EPS or diluted EPS is the driver of market value. In many cases the two are very close and the gap is not significant. In some cases, however, the spread between the two EPS figures is fairly large.
    In addition to earnings per share (EPS) investors in stock shares of publicly owned companies closely follow two other ratios: (1) the dividend yield ratio and (2) the price/earnings ratio (P/E). The dividend yield and P/E ratios are reported in the stock trading tables published in the Wall Street Journal, which demonstrates the importance of these two market value ratios for stock shares.
    Dividend Yield Ratio
    The dividend yield ratio equals the amount of cash dividends per share during the most recent, or trailing, 12 months divided by the current market price of a stock share. The dividend yield ratio is the measure of cash income from a share of stock based on its current market price. The annual return on an investment in stock shares includes both the cash dividends received during the period and the gain or loss in market value of the stock shares over the period. The calculation 53

    F I N A N C I A L R E P O R T I N G

    of the historical rate of return for a stock investment over two or more years and for a stock index such as the Dow Jones 30

    Industrial or the Standard & Poor’s 500 assumes that cash dividends have been reinvested in additional shares of stock.

    Of course, individual investors may decide not to reinvest their dividends. They may spend their dividend income or put the cash flow into other investments.

    Price/Earnings Ratio

    The market price of stock shares of a public business is divided by its most recent annual EPS to determine the price/earnings ratio:

    Current market price of stock share

    ᎏᎏᎏᎏᎏᎏ
    Earnings per share (either basic or diluted EPS)

    = price/earning ratio, or P/E

    Suppose a company’s stock shares are trading at $60.00

    per share and its EPS for the most recent year (called the trailing 12 months) is $3.00. Thus, its P/E ratio is 20. By the way, the Wall Street Journal uses diluted EPS to report P/E

    ratios in its stock trading tables. Like the other ratios dis-

    cussed in this chapter, the P/E ratio is compared with indus-

    trywide and marketwide averages to judge whether it’s too high or too low. I remember when a P/E ratio of 8 was typical.

    TEAMFLY
    Today P/E ratios of 20 or higher are common.

    The stock shares of a privately owned business are not actively traded, and thus the market value of its shares is diffi-

    cult to ascertain. When shares do change hands occasionally, the price is usually kept private between the seller and buyer.

    Nevertheless, stockholders in these businesses are interested in what their shares are worth. To estimate the value of