Question

In: Accounting

Since the PE ratio measures how much investors are willing to pay per dollar of current...


Since the PE ratio measures how much investors are willing to pay per dollar of current earnings, lower PEs are often taken to mean that the firm has significant prospects for future growth.
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Expert Solution

The statement is wrong. Higher PEs are taken to mean that the firm has significant prospects for future growth.

The P/E ratio shows the relationship between a company's stock price and its earnings per share of stock issued by it. The P/E ratio is calculated by dividing a company's current stock price by its (EPS).

A company's stock price shows the value that investors are currently placing on that investment,P/E ratio indicates how much investors are willing to pay for every penny of earnings. The market price of a given stock is required to calculate its P/E ratio, but in various ways, the P/E ratio provides better insight into the stock's growth potential.

The general viewpoint is that a high P/E ratio indicates investors expecting higher earnings. However, a stock with a high P/E ratio is not necessarily a better investment than one with a lower P/E ratio because a higher P/E ratio can sometimes indicate that the stock is being overvalued.Investing in an overvalued stock comes with the risk of losing money if it doesn't meet high earnings expectations of investors.

On the other hand, a low P/E ratio may indicate that the stock is undervalued. Investors can often buy undervalued stock at a discount and can earn profit when the price of that stock elevates. It is worth noting that sometimes a low P/E ratio indicates a genuine lack of growth potential.

comparing a company's P/E ratio with that of similar companies in the competition or industry to get a better sense of whether the stock you're proposing to purchase is overvalued or undervalued.


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