Question 22.3: Calculate NewWorld’s price-earnings ratio, before and after ...

PLAN
The price-earnings ratio is price per share / earnings per share. NewWorld’s price per share is $100 both before and after the takeover, and its earnings per share is $5 before and $6.25 after the takeover.

EXECUTE
Before the takeover, NewWorld’s price-earnings ratio is

P/E=\frac{\$100\text{/share}}{\$5\text{/share}} = 20

After the takeover, NewWorld’s price-earnings ratio is

P/E=\frac{\$100\text{/share}}{\$6.25\text{/share}} = 16

EVALUATE
The price-earnings ratio has dropped to reflect the fact that after taking over OldWorld, more of the value of NewWorld comes from earnings from current projects than from its future growth potential.