2.4 Market & Valuation Ratios

Earnings Per Share

Earnings per share (EPS) is the foundation of equity valuation.

• Basic EPS = (net income - preferred dividends) / weighted-average common shares outstanding. Preferred dividends are subtracted because they are not available to common holders.
• Diluted EPS = (net income - preferred dividends, adjusted) / (weighted-average shares + potential shares from options, warrants, and convertibles).

Diluted EPS assumes all dilutive securities convert to common stock, increasing the share count. Therefore diluted EPS is always less than or equal to basic EPS, never higher. Anti-dilutive securities (those that would raise EPS) are excluded from the diluted calculation.

EPS Worked Example

Assume: net income $1,100; preferred dividends $100; weighted-average common shares 500; options that would add 50 shares if exercised.

The diluted figure is lower because the same earnings spread across more shares. Analysts focus on diluted EPS as the conservative measure.

Weighted-average shares matter when shares are issued or repurchased mid-year. A firm that issues new stock in July weights those shares for only half the year, so the denominator is not simply the year-end share count. The exam may give issuance dates expecting you to weight them.

Note that EPS is a per-share figure, so it cannot be compared directly across companies; a $10 EPS is not "better" than a $2 EPS without knowing share counts and prices. That is why P/E, which scales price by EPS, is the more useful cross-company gauge.

Valuation Multiples

• Price-to-earnings (P/E) = market price per share / EPS. The price investors pay per dollar of earnings; a high P/E implies high growth expectations or low risk.
• PEG ratio = P/E / annual earnings growth rate (in percent). Normalizes P/E for growth; a PEG near 1.0 is often viewed as fairly priced.
• Price-to-book (market-to-book) = market price per share / book value per share. Compares market value to accounting net worth.
• Book value per share = (total equity - preferred equity) / common shares outstanding.

With a $40 price and $2.00 EPS, the P/E is 20x. If earnings are growing 20% per year, PEG = 20 / 20 = 1.0, suggesting the price is reasonable relative to growth.

Reading the Multiples

P/E and price-to-book are most useful within an industry and against a firm's own history. A bank trading at 1.2x book and a software firm at 9x book are not comparable; their asset bases and growth profiles differ fundamentally.

Dividend Ratios

• Dividend yield = annual dividend per share / market price per share. The cash income return on the stock.
• Dividend payout ratio = dividends / net income (or dividends per share / EPS). The share of earnings paid out.
• Retention (plowback) ratio = 1 - payout ratio. The share reinvested in the business.

With $0.80 dividend per share and $2.00 EPS, payout = 0.80 / 2.00 = 40%, so retention = 60%. At a $40 price, dividend yield = 0.80 / 40 = 2.0%. Mature firms pay out more; high-growth firms retain more to fund expansion. The sustainable growth rate = retention ratio x ROE links payout policy to growth potential.

Earnings Quality and Market Ratios

Earnings quality describes how well reported net income reflects sustainable, cash-backed economic performance. High-quality earnings are recurring, conservatively measured, and supported by operating cash flow. Low-quality earnings rely on one-time gains, aggressive estimates, or accruals that have not converted to cash.

Market ratios are only as reliable as the earnings beneath them:

• A low P/E may look cheap, but if EPS is inflated by non-recurring gains, the stock is not truly bargain-priced.
• A high market-to-book may reflect genuine intangible value or an overvalued stock.

Trap: Comparing P/E across firms with different accounting policies, capital structures, or one-time items is misleading. Always adjust EPS for non-recurring items before drawing valuation conclusions.

How Analysts Use Market Ratios

Market ratios serve three practical purposes on the exam and in practice:

• Relative valuation: apply a peer-group multiple (say, an industry average P/E of 18x) to a target's earnings to estimate a fair price.
• Signaling: a payout or dividend change conveys management's confidence; a dividend cut often signals distress, an increase signals durable earnings.
• Growth analysis: the sustainable growth rate (retention x ROE) shows how fast a firm can grow from retained earnings without new external financing.

For instance, a firm retaining 60% of earnings and earning a 15% ROE can sustainably grow at 0.60 x 0.15 = 9% per year. Exceeding that rate requires issuing debt or equity. Tying payout policy, ROE, and growth together is a frequent CMA Part 2 essay theme.