Question

Why is the price-earnings ratio seen as a critical piece of data for managers and investors? What actions could a manager take to try to positively impact the price-earnings ratio?

Answer 1

The investors and investment managers take price earnings ratio critically because it serves as a measure to decide if the market price are over or under valued. A higher P/E ratio indicates the stock is overvalued in the markets in relation to its earnings and undervalued in case the ratio is lower. Thus potential investors/managers use this ratio while buying and holding undervalued stocks for investment and selling or avoiding overvalued stocks.

The techniques used for positively impacting the P/E Ratio are as follows:

• Reduction of debt component: By reduction of debt component, financial charges will reduce, thus after tax profits will rise keeping more earnings potential for share holders.
• Keeping equity base short: Thus the potential for increase in earnings to equity share holders is possible resulting in positive impact on the ratio.
• Bringing growth in profits and in sales.
• Expansion of sales into varied product lines as well as geographic lines.
• Building intangible factors such as branding, reputation, goodwill, etc
• Favorable socio economic factors affecting the business and industry.