Price-to-Earnings Ratio

Ferncliff Media trades at 48 dollars per share and reported earnings of 3.00 dollars per share over the trailing twelve months. Companies in its industry trade at an average price-earnings ratio of 12. What is Ferncliff's price-earnings ratio, and what does the comparison suggest?

1. A.6.25, indicating the market values Ferncliff at a discount to its peers.This is the earnings yield expressed as a percentage, produced by dividing earnings by price. The price-earnings ratio divides price by earnings.
2. B.16, meaning investors pay more per dollar of earnings than for the average peer, a premium that may reflect higher expected growth or overvaluation.Correct. 48 divided by 3.00 equals 16, above the industry average of 12.
3. C.16, which means the stock is expected to return 16 percent per year.The multiple is right but the interpretation is not. A price-earnings ratio is a valuation measure, not a return forecast.
4. D.12, because a company's price-earnings ratio converges to its industry average by definition.No such convergence exists. The ratio is computed from the company's own price and earnings.

Why: The price-earnings ratio divides the market price per share by earnings per share, expressing how many dollars investors will pay for each dollar of current earnings. Here 48 divided by 3.00 equals 16. Trading at 16 times earnings against an industry average of 12 means the market is paying a premium for Ferncliff. A premium multiple is ambiguous on its own: it may reflect superior expected earnings growth, lower perceived risk, or simply an overvalued stock, which is why analysts pair the ratio with growth and quality measures rather than reading it in isolation.

A comparable company trades at $60 per share and reports earnings per share (EPS) of $4.00. What is its price-to-earnings (P/E) multiple?

1. A.$56.00Wrong. This subtracts the two figures; P/E is a ratio, not a difference.
2. B.0.067xWrong. This inverts the ratio (EPS ÷ price), producing an earnings yield instead of P/E.
3. C.$64.00Wrong. This adds the two figures; P/E is a ratio, not a sum.
4. D.15.0xCorrect. $60 ÷ $4.00 = 15.0x.

Why: P/E = price per share ÷ EPS = $60 ÷ $4.00 = 15.0x.

As a rule of thumb, an all-stock acquisition with no assumed synergies is generally accretive to the acquirer's EPS when:

1. A.The target's P/E multiple is higher than the acquirer's P/E multipleWrong. This is backwards — a higher target P/E relative to the acquirer's tends to be dilutive, not accretive.
2. B.The two companies' P/E multiples are exactly equalWrong. Equal P/E multiples, with no premium and no synergies, tend to produce a roughly neutral result, not clear accretion.
3. C.The acquirer's P/E multiple is higher than the target's P/E multipleCorrect. This is the standard rule-of-thumb condition for accretion in a no-premium, no-synergy all-stock deal.
4. D.The acquirer's share price is higher than the target's share price in absolute dollar termsWrong. Absolute share price levels are irrelevant to accretion/dilution; the relevant comparison is the P/E multiples.

Why: When the acquirer's P/E multiple is higher than the target's, the acquirer is effectively "buying" a dollar of target earnings for fewer of its own (relatively expensive) shares than a dollar of its own earnings would cost — which mechanically tends to raise pro forma EPS, before considering any premium paid or synergies.

Bellcross's pre-deal trading P/E is 18x and Fenwick's pre-deal trading P/E is 12x, which under the standard rule of thumb suggests an all-stock acquisition of Fenwick should be accretive. Bellcross then agrees to pay a 50% premium over Fenwick's pre-deal share price. What does that premium do to the reliability of the rule-of-thumb conclusion?

1. A.The premium has no effect, because P/E multiples are unaffected by the price paid in a dealWrong. The premium directly raises the effective multiple paid for the target's earnings, which the pre-deal trading P/E does not reflect.
2. B.The rule of thumb replaces the need for any further calculation once the premium is setWrong. The rule of thumb is a shortcut for a no-premium, no-synergy scenario; once a real premium is added, the actual pro forma math is needed.
3. C.The premium always makes the deal more accretive, because it signals confidence in the targetWrong. A premium raises the cost of the deal and, all else equal, works against accretion, not for it.
4. D.The premium raises the effective multiple paid for Fenwick's earnings, so the pre-premium P/E comparison no longer guarantees accretionCorrect. The actual exchange ratio and pro forma EPS, inclusive of the premium, must be recalculated rather than relying on the unaffected trading multiples.

Why: The rule of thumb compares unaffected, pre-deal trading multiples. Once a 50% premium is added, the effective multiple Bellcross is actually paying for Fenwick's earnings rises well above Fenwick's 12x trading multiple — potentially above Bellcross's own 18x — so the pre-premium comparison no longer guarantees accretion, and the exchange ratio and pro forma EPS must be recalculated using the actual deal price.