Financial Analysis of Companies

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1. Under what circumstances might a company have a high p/e ratio even when investors are not optimistic about the company's future prospects?

Typically, the higher a price/earning ratio, the more the market is willing to pay for the company's earnings. However, investors may interpret a high price/earning ratio as an overpriced stock; or investors may be over overly enthusiastic about a company's future and bid up the stock price, leading to a high price/earning ratio. In order to determine if a price/earning ratio is reasonable it is important to make comparisons between the company's valuation and other similar companies within the same industry. Included in this analysis could be dollars per day per store, and sales per square foot. An investor might also consider if the earnings being used in the price/earning calculation are historical or projected. It would be important to consider these aspects before randomly investing in a stock due to a high price/earning ratio.

Reference:
Zacks Investment Research. How to Use the Price to Earnings Ratio. Retrieved from http://www.zacks.com/education/articles.php?id=30.

2. Assume that you have several thousand dollars to invest in the stock market. Given that "people will always have to eat," you have decided to explore the possibility of investing in Wendy's and McDonald's. Your analysis of each company's financial statements reveals that both have negative working capital and both have current and quick ratios of less than 1 to 1. Assume that neither Wendy's nor McDonald's accepts debit or credit cards. Based on your findings, should you be concerned about the short-term liquidity (solvency) of these two companies? Explain.

Working capital is a measure of a company's ability to pay off short term debt as well as finance its day to day operations. If a company has negative working capital that means the company must take on additional debt to finance its' daily operations. In addition, it must have a plan for the future to resolve this deficit, in order to survive and thrive. Companies cannot exist in the long run working with negative working capital! Current ratio of less than 1 to 1 indicates that the companies have fewer assets than their debt. Assets might be real estate, inventory or pre-paid debt (credit/debit cards). Quick ratio is similar to current ratio but without the inventory or prepaid assets. In other words, could the companies meet their obligations (immediate liabilities) with their current assets? Since both companies reveal a negative working capital and both have ...