One of the more closely watched ratios by investors is the price/earnings or P/E ratio. By dividing price per share by earnings per share, analysts get insight into the value the market attaches to a company’s earnings. More specifically, a high P/E ratio (in comparison to companies in the same industry) may suggest the stock is overpriced. Also, there is some evidence that companies with low P/E ratios are underpriced and tend to outperform the market. However, the ratio can be misleading.

P/E ratios are sometime misleading because the E (earnings) is subject to a number of assumptions and estimates that could result in overstated earnings and a lower P/E. Some analysts conduct “revenue analysis” to evaluate the quality of an earnings number. Revenues are less subject to management estimates and all earnings must begin with revenues. These analysts also compute the price-to-sales ratio (PSR = price per share = sales per share) to assess whether a company is performing well compared to similar companies. If a company has a price-to-sales ratio significantly higher than its competitors, investors may be betting on a stock that has yet to prove itself. [Source: Janice Revell, “Beyond P/E,” Fortune (May 28, 2001), p. 174.]

Instructions

(a) Identify some of the estimates or assumptions that could result in overstated earnings.

(b) Compute the P/E ratio and the PSR for Tootsie Roll and Hershey’s for 2005.

(c) Use these data to compare the quality of each company’s earnings.