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chapter 22 a closer look at financial statements

Chapter 22 takes another look at financial statements, adding more detail to the initial coverage in Chapter 4. Read Finkler, Chapter 22.

You’ve already used the balance sheet to find the book value per share. Another way of using accounting data to estimate value is to look at the statement of earnings. The price or value per share is based on the future stream of earnings a company can generate. An analyst may apply a multiplier to the current earnings per share if he or she believes the company capable of sustaining this level of earnings into the future.

You can see the earnings multipliers that are reflected in current stock prices by calculating the Price-to-Earnings ratio (PE for short). This is done by taking the current market price and dividing by the most recent annual earnings per share. If we do this for Stanley using the $50 market price and $3.55 basic earnings per share from continuing operations from 2006, it results in a PE of 14.1. The common way of talking about this is to say “Stanley Works is trading at 14 times earnings.”

A rough rule of thumb for mature U.S. Corporations is that a PE ratio exceeding 10 implies some expected earnings growth in the future. This comes from the finance equation which expresses the earnings multiplier as [ 1 / k – g ] where k is the expected annual yield on equity and g is the long run future growth rate in earnings. If current earnings are expected to persist in the long run ( g=0.0) and an expected yield on equity is approximately 10% (k=0.10) the expression becomes [ 1 / .10 ] or 10.

To see if Stanley deserves some expected growth, go to the Income Statement tab on your worksheet and input the Sales figures for the 3 years, and the basic earnings per share from continuing operations. As you can see, Stanley, although a mature company, has exhibited growth in sales and earnings per share, so a PE of 14 may be reasonable.

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