Chapter 2, Problem 1DQ

Discuss some financial variables that affect the price-earnings ratio. (LO2-2)

Summary Introduction

To Explain: The financial variables that affect the the price/earnings ratio.

Introduction:

Price/Earnings ratio:

The price/earnings ratio is a way of valuing a company's shares and provides information about the share price being overvalued or undervalued.

Answer to Problem 1DQ

Factors like earnings growth rate, company's share price, and quality of management affect the price/earnings ratio.

Explanation of Solution

The first factor is the earnings growth rate. An increase in the earnings of the firm with the share price being constant means that the share price of the company is undervalued.

Similarly, the second factor, which is the company's share price, affects the ratio as well. An increase in the share price of the company with the earnings being constant means that the share price of the firm is overvalued.

The third factor is the quality of management. It affects the ratio because the way the management works and is able to generate sales and earnings are important, and hence, it plays a crucial role in determining the ratio.

Conclusion

The main purpose of the price/earnings ratio is to provide information about the stability of the business operations of a firm in order to enable comparison with its peers, work upon its limitations, and consequently, make the required changes.