Question

May Stewart, CFA, a retail analyst, is performing a P/E-based comparison of two hypo­thetical jewelry stores as of early 2009. She has the following data for Hallwhite Stores (HS) and Ruffany (RUF).

HS is priced at $44. RUF is priced at $22.50.

HS has a simple capital structure, earned $2.00 per share (basic and diluted) in 2008, and is expected to earn $2.20 (basic and diluted) in 2009.

RUF has a complex capital structure as a result of its outstanding stock options. More­over, it had several unusual items that reduced its basic EPS in 2008 to $0.50 (versus the $0.75 that it earned in 2007).

For 2009, Stewart expects RUF to achieve net income of $30 million. RUF has 30 million shares outstanding and options outstanding for an additional 3,333,333 shares.

A.) Which P/E (trailing or forward) should Stewart use to compare the two companies’ valuation?

B.) Which of the two stocks is relatively more attractive when valued on the basis of P/Es (assuming that all other factors are approximately the same for both stocks)?

Answer 1

a) As RUF had several unusual items that impacted its 2008 EPS, Stewart should use forward (2009 & diluted) P/E to compare the two companies' valuation

b) As per data given in the question:

Company	Price	2009 EPS	Forward P/E
HS	44.00	2.20	20.0
RUF	22.50	=30/(30+3.333333) = 0.90	25.0

Note: Diluted EPS = net income / diluted shares outstanding.

On the basis on P/E ratios above, HS is relatively more attractive given its lower P/E mutiple which means the stock is cheaper on a relative basis.