Quantitative Methods of Evaluating Businesses and Investments - The Income Statement: Key Ratios

Formula 7.7: The Interest Coverage Ratio allows you to determine how easily a company can meet debt payment obligations. The lower the ratio, the more the company is burdened by debt expense. When a company's bond interest coverage ratio is less than 1.5, its ability to meet coupon payment obligations may be questionable. These company's bonds would most likely have low credit ratings.
Example: Quality HomeBuilding's earnings before interest and taxation (EBIT) last year totaled $122 million, and its annual interest payments equaled $33 million. What was its interest coverage ratio?

Interest coverage ratio = $122,000,000 / $33,000,000 = 3.70

Formula 7.8: The Price-Earnings (P/E) ratio is a valuation ratio used to determine how the market has valued the share in comparison to its earnings per share. In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E.

However, the P/E ratio doesn't tell us the whole story by itself. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, or to the market in general, or against the company's own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E), as each industry has much different growth prospects.

The P/E is sometimes referred to as the "multiple" because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings. It is important that investors note an important limitation when using the P/E measure and do not base their investment decision on this measure alone. The denominator (earnings) is based on an accounting measure of earnings, which is susceptible to manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number.

Example: Medical Equipment Corp. last year reported earnings per share of $2.35, and its current stock price is $27.82. What is its Price-Earnings ratio?

P/E ratio = $27.82 / $2.35 = 11.84

Look Out!
You may be required during the exam to calculate a company\'s earnings per share as part of a question about its P/E ratio. To calculate earnings per share, divide net income by number of shares outstanding.

Example: Big Media Inc. had net income of $75 million last year. Its current stock price is $6.20, and it has 520 million shares outstanding. What is Big Media's P/E ratio?

  1. Earnings per share = $75,000,000 / 520,000,000 shares = .14
  2. 2. P/E ratio = $6.20 / $.14 = 44.29

The P/E is the most important and most widely used ratio; be sure to check out the tutorial Understanding the P/E Ratio to learn how to use this measure and its downside.

Formula 7.9: The Price-to-Book (P/B) or Price/Equity ratio, is a valuation ratio used to compare a stock's market value to its book value. A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that something is fundamentally wrong with the company. As with most ratios, be aware that this varies a fair amount by industry.

Example: Top Notch Supermarkets Inc. has a current stock price of $55.74 and book value of $21.36 a share. What is the company's Price-to-Book ratio?

Price-to-Book ratio: $55.74 / $21.36 = 2.61

Look Out!
To calculate Price-to-Book ratio, you may be required to determine on your own a company\'s book value per share from given information. Consider the following example:

Example: New Edge Technology Inc. has assets of $991 million, liabilities of $125 million, 542 million outstanding shares and a current stock price of $8.92. What is New Edge Technology's Price-to-Book ratio?

  1. Book value = $991,000,000 - $125,000,000 = $866,000,000
  2. Book value per share = $866,000,000 / 542,000,000 = $1.60
  3. Price-to-Book ratio = $8.92 / $1.60 = 5.58

The Price-to-Book ratio also gives some idea of whether you're paying too much for what would be left if the company went bankrupt immediately. Learn more about this ratio, including its downside, in the article, Value By the Book.

Balance Sheet
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