Principles of Financial Accounting: Stockholders' Equity - Price-Earnings Ratio

What It Is

The Price-Earnings Ratio (P/E Ratio) is a financial metric that compares a company's stock price to its earnings per share (EPS). It helps investors evaluate a company's stock value and growth potential. For example, if a company's stock price is $50 and its EPS is $5, the P/E Ratio would be 10 ($50 ÷ $5). This means that investors are willing to pay $10 for every dollar of earnings.

Key Concepts & Formulas

• Earnings Per Share (EPS): EPS is calculated by dividing net income by the number of outstanding shares. EPS = Net Income ÷ Outstanding Shares. For example, if a company has net income of $100,000 and 20,000 outstanding shares, EPS would be $5 ($100,000 ÷ 20,000).
• Price-Earnings Ratio (P/E Ratio): The P/E Ratio is calculated by dividing the stock price by EPS. P/E Ratio = Stock Price ÷ EPS. Using the previous example, the P/E Ratio would be 10 ($50 ÷ $5).
• Gross Profit: Gross profit is the difference between sales and cost of goods sold (COGS). Gross Profit = Sales – COGS. For example, if a company has sales of $100,000 and COGS of $60,000, gross profit would be $40,000.
• Operating Expenses: Operating expenses are the costs associated with running a business, excluding COGS. Operating Expenses = Total Expenses – COGS. For example, if a company has total expenses of $80,000 and COGS of $60,000, operating expenses would be $20,000.
• Net Income: Net income is the profit earned by a company after deducting all expenses. Net Income = Sales – COGS – Operating Expenses. Using the previous examples, net income would be $20,000 ($100,000 – $60,000 – $20,000).
• Debit and Credit Rules: In accounting, debits increase assets and expenses, while credits increase liabilities and equity. Debit = Assets + Expenses, Credit = Liabilities + Equity.
• Journal Entry Format: Journal entries are recorded in the following format: Dr. Account Name $xxx, Cr. Account Name $xxx. For example, if a company purchases inventory for $10,000, the journal entry would be: Dr. Inventory $10,000, Cr. Cash $10,000.

Journal Entry Examples

1. Dr. Inventory $10,000, Cr. Cash $10,000 (purchasing inventory) Explanation: Debit inventory to increase its value, and credit cash to decrease its value.

2. Dr. Accounts Payable $5,000, Cr. Purchases $5,000 (purchasing on credit) Explanation: Debit accounts payable to increase its value, and credit purchases to increase its value.

3. Dr. Salaries Expense $5,000, Cr. Salaries Payable $5,000 (accruing salaries) Explanation: Debit salaries expense to increase its value, and credit salaries payable to increase its value.

Common Mistakes

1. Mistake: Confusing debits and credits for expense accounts. Correction: Remember that debits increase assets and expenses, while credits increase liabilities and equity. Use the mnemonic "ADE" (Assets, Drawings, Expenses) to help you remember.
2. Mistake: Not considering the normal balance of an account when recording a journal entry. Correction: Always consider the normal balance of an account when recording a journal entry. For example, if an account has a normal balance of debit, you should debit it when recording a journal entry.
3. Mistake: Not using the correct journal entry format. Correction: Use the correct journal entry format: Dr. Account Name $xxx, Cr. Account Name $xxx.

Exam Tips

1. Tip: Pay attention to the normal balance of an account when recording a journal entry.
2. Tip: Use the mnemonic "ADE" (Assets, Drawings, Expenses) to help you remember the debit and credit rules.
3. Tip: Be careful when recording journal entries for accruals and prepayments, as they can be tricky.

Quick Practice

1. What is the adjusting entry for accrued salaries of $5,000? Answer: Dr. Salaries Expense $5,000, Cr. Salaries Payable $5,000 Explanation: Debit salaries expense to increase its value, and credit salaries payable to increase its value.

2. If a company has sales of $100,000 and COGS of $60,000, what is its gross profit? Answer: $40,000 Explanation: Gross profit is the difference between sales and COGS.

3. If a company's stock price is $50 and its EPS is $5, what is its P/E Ratio? Answer: 10 Explanation: The P/E Ratio is calculated by dividing the stock price by EPS.

Last-Minute Cram Sheet

1. Dividends are NOT an expense – they go directly to retained earnings.
2. Assets have normal debit balances.
3. Expenses have normal debit balances.
4. Liabilities and equity have normal credit balances.
5. Gross profit = Sales – COGS.
6. Operating expenses = Total expenses – COGS.
7. Net income = Sales – COGS – Operating expenses.
8. P/E Ratio = Stock price ÷ EPS.
9. EPS = Net income ÷ Outstanding shares.
10. Debit = Assets + Expenses, Credit = Liabilities + Equity.