Question

7. 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

Price-earnings ratio is computed by dividing the market price of a company's share by its earnings per share (EPS). It is seen as a very critical piece of data for managers and investors because it assists them in the determination of the market value of a stock in comparison to the earnings of the company. In simple words, it indicates the price which the market is willing to pay today for a stock on the basis of its past or future earnings, which ultimately determines the overvaluation or undervaluation of an stock in comparison to other stocks or the industry at large.

A high P/E ratio indicates high stock price in relation to company's earnings, thus resulting in overvaluation and vice-versa. A high P/E ratio shows that the investors are willing to pay a higher price for a stock today due to future growth expectations. PE ratio shows the market expectations, hence earnings become very much important in the valuation of the stock of a company. For a high PE ratio, it becomes very much necessary to have sufficient past or expected profits, sound growth rate, required rate of return and optimum dividend and retention policy because all these factors have either a direct or an indirect bearing on the market expectations.