Two online magazine companies reported the following in their financial statements: BetterWorth Outdoor Fun 2018 2017 2018 2017 Net income $ 111,000 $ 108,804 $ 92,420 $ 172,373 Total stockholders' equity 597,186 522,814 457,151 477,049 Earnings per share 3.40 3.39 2.30 4.18 Stock price when annual results reported 54.90 51.54 33.05 60.20 Required: 1-a. Compute the 2018 ROE for each company. 1-b. Which company appears to generate greater returns on stockholders’ equity in 2018? 2-a. Compute the 2018 P/E ratio for each company. 2-b. Which company do investors appear to value more?

BetterWorth and Outdoor Fun ROE and P/E Ratio Analysis:

1-a) Computation of 2018 ROE for each company.

ROE = Return on Equity.  It is a percentage of the net income over equity.  It is best to use the average equity, if given two balance sheets.  See explanation for further clarification.

Average Equity = Two balance sheets' equity divided by 2.

BetterWorth's Average Equity = (597,186 + 522,814) / 2 = 560,000

Outdoor Fun's Average Equity = (457,151 + 477,049) / 2 = 467,100

BetterWorth's 2018 ROE = 111,000 / 560,000 x 100 = 19.82%

Outdoor Fun's 2018 ROE = 92,420 / 467,100 x 100 = 19.79%

1-b) BetterWorth's appears to be generating greater returns on stockholders' equity in 2018.  It generated 19.82% as against Outdoor Fun's 19.79%, especially with the use of average equity.

2-a) Computation of 2018 P/E Ratio for each company:

P/E Ratio = Price/Earnings Ratio.  It is expressed as the market price per share divided by earnings per share.

BetterWorth's 2018 P/E Ratio = 54.90 : 3.4 = 16.15 : 1

Outdoor Fun's 2018 P/E Ratio = 33.05 : 2.30 = 14.37 : 1

2-b) Investors appear to value BetterWorth more than Outdoor Fun.  This is because investors are ready to pay 16.15 times more for each unit of the earnings of BetterWorth.  For Outdoor Fun, investors are only willing to pay 14.37 times more for each unit of its earnings.

Explanation:

A) ROE = Return on Equity.  It is expressed as a percentage of net income over average equity.  In the above calculations, we used the average equity.  The reason is this: average equity smoothens the mismatch between the income statement and the balance sheet.

But, what does ROE measure?  It measures a company's management effectiveness in using assets to make profits for shareholders.

Had we used the 2018 equity, Outdoor Fun would have appeared to have performed relatively better than BetterWorth over ROE.

B) P/E ratio relates a company's share price to its earnings.  The P/E ratio shows that the company's stock is overvalued or undervalued.  It depicts investors' confidence or lack of it in the company's ability to produce more or less earnings.  Without earnings expectation, investors cannot price a company's stock highly.  It is therefore a stock valuation tool widely used by financial analysts and investors.