 Personal Finance Practice Problem using OneNote. Earnings per share and price earnings ratio. Prepare to get financially fit by practicing personal finance. You're not required to, but if you have access to OneNote, would like to follow along. We're in the icon left-hand side. Practice Problems tab in the $1270 Earnings Per Share and Price Earnings Ratio tab. Also, take a look at the Immersive Reader tool. The Practice Problems, typically in the text area too, with the same name, same number, but with transcripts, transcripts that could be translated into multiple languages and either listened to or read in them. We're looking at tools that can help us out with our investment decisions related to stocks, stocks representing an ownership interest in a corporation, corporations being separate legal entities that have their ownership interest broken out into fixed or even units of shares or stocks. And we're also usually thinking about publicly traded companies, those which have decided to be on public exchanges, making those corporations more transparent, allowing us to get access to more information such as the financial statements to make our investment decisions. Also, note that investing in stocks is a little bit different than investing in other tools such as mutual funds or ETFs where you're kind of grouping together or looking to diversify under the tool of a mutual fund or an ETF. Keeping that in mind, we're calculating the earnings per share and price earnings ratio, very common calculations. We see the calculation down below. The earnings per share equals the net income of the company. The net income could be found if you get the financial statements of the company. We're typically looking at the financial statements on a yearly basis oftentimes, although you could look at other intervals as well. And it would be on the income statement, basically the bottom line of the income statement, revenue minus expenses. Remember that you can get some of these terms a little bit confused in terms of revenue or income and then net income and like net sales. Sometimes you hear these terms. So the net income, we're thinking the bottom line after the expenses in essence. And then we're going to divide that by the average outstanding shares of the company stock. Now note that you might think of it as simply the outstanding shares as of the time you do the calculation, which will probably be the end of the period, right? You're going to get the financial statements for a year, year ended, let's say December 31st and do the calculation as of that point in time. So why would you take the average outstanding shares? Well, in that case, you're trying to look for a point in the timeframe that represents all the points in that year in essence. And you could do that by possibly looking at the prior financial statements in the prior year and look at the outstanding shares at that point and then add them to the outstanding shares at the current timeframe, dividing them by two to get some kind of average. That's not a perfect calculation, but it's an attempt to get an average. Why is that important or why might that be necessary? One, the net income note is a timing statement or timing term. It's on the income statement, meaning you can only say how much income you have or how much revenue or net income you have generated if you give a timeframe such as a year, a quarter, a month will typically be thinking about in essence a year. Whereas when you look at the number of shares outstanding, that actually represents a point in time. So typically if I ask a company or try to look up how many shares are outstanding as of 1231, I can look up that point in time. So notice you're dealing with something that's a range in time and a point in time. In order to match up the point in time and the range in time, you might try to take an average for the point that best represents some point over the range of say a year. This may or may not be as important as well depending on the activity and the shares that have been outstanding. For example, a company might issue more shares in order to generate more revenue, but that doesn't happen all the time. Most of the time the trading that's happening in the stocks is on the secondary market not from the company issuing more shares. They'll typically issue in the initial public offering and then possibly periodically after that point in time or there might be stock splits that happen or buybacks that happen as well, meaning there's changes in the number of shares over the time frame whereas you could have a situation where there wasn't much change in the number of shares over the time frame as well. Okay, let's do that first calculation company information up top. We're going to say the earnings is going to be the 6,500,000. The shares, the shares of common stock are the 2,900,000. The earnings would be found on the income statement in essence, the shares, the balance sheet or on the financial statements and the stock market price is going to be 40. Notice the 40 is not something that would be determined by the financial statements by management, by the company. It would be determined by the market, by supply and demand of these fixed units of stocks that are currently trading for the $40 because they're all uniform. They're all the same in nature. We can say that that's the actual stock price. So the earnings going to be the 6,500,000. Remember that's net income. Notice earnings is another kind of somewhat ambiguous term because you know, it could represent, you might think of it as revenue or net income. So you got to be careful with how those terms are used and the context in which they're going to be used. So it's the bottom line of the income statement in essence. And then we've got the shares of common stock. So these are the number of shares outstanding. They represent even or equal units of ownership interest. They're all basically the same. One person could own of course, multiple shares of common stock but still have them broken out into those fixed units. And that's going to give us our 2.24 about. So if we got our earnings 6,500,000 divided by the average units of ownership interest. We're saying there's 2,900,000 of them out there. That's going to give us our 2.24, $2.24 about of earnings on a per unit, not per owner, but per stock because an owner might own multiple stocks for example but per fixed unit, $2.24. Now note that if we had preferred stock we might alter the formula a little bit because then we would take the net income of the company minus the dividends to the preferred stockholders because the preferred stockholders will be paid first. That's why it's a preferred stock. Don't get that preferred term confused with the preferred stock being safe better than common stock. It just has different characteristics so that terms a little bit misleading but they get paid first generally. So you'd have to take the net income minus the preferred stock if there was any outstanding. And again notice here we divided by the shares of common stock as of like a point in time as of the end of the year. It depends on what the circumstances are in terms of whether you might want to try to take an average which would be like you could take basically again these shares that were outstanding at the end of last year add them to the current shares in the current year and divide them by two. There's no perfect measure because again you're trying to compare something that's a point in time to a time range but those are some other things just to keep in mind. And then we've got the price earnings ratio the price earnings ratio is simply going to be taking the $40 which is determined by the market that's what the stock is currently selling for if it's traded on a public exchange we're going to know what it is because we know that those stocks are probably going to be trading all the time. So we take the 40 divided by the 2.24 and that's going to give us our price earnings ratio of the 1785. So notice what we're saying here we're saying okay this is the earnings on a per share basis and now we're going to take the price that the stock is selling for if it's selling for $40 what is the or how many times over is the earnings per share on a per share basis dividing into that 40. So we're going to take the 40 divided by the 2.24 and we get about 17.85 in essence. So in essence you would say okay well if I paid the $40 for one share and I earned $2.24 let's say this was on a yearly basis then it would take 17 or 18 years to in essence get a return on that earnings per share. That's just a quick kind of calculation. Now note that that number then the 17.87 is useful in that it's generally going to be used as a relative comparison to other kind of stocks typically within possibly the index or possibly the stock itself in prior periods or possibly to other stocks that are currently in the same kind of area or categorization or zone. So we're always doing some comparison and benchmarking to say other stocks to try to paint a picture use a bunch of different ratio analysis to try to paint a picture of what might be happening in the future what's the true valuation of these different stocks so that we can then make decisions based on that going forward. It's also important to realize that this earnings per share of the $2.24 does not necessarily mean that we're going to be receiving in the form of dividends of $2.24. That's basically what the company has earned on say a per share basis. Now we're hoping that we're going to get some value from that either in the form of possibly some of it in the form of a dividend or if they don't give us a dividend we would expect that they would take those earnings and roll them back into the company investing in assets and machinery and equipment for example to grow and that would then increase the value of the company which hopefully would be reflected in the stock price. So the stock price will typically increase if the company is appropriately taking the earnings that they're earning and rolling them back into the company increase in the value of the company and the earnings potential going out into the future. But again just remember that that earnings per share is not necessarily anything that we're going to realize at this point in time it's just allocating the company's earnings over the number of shares outstanding.