Question

Explain how ROE, ROA and P/E are affected when new common stock is issued by a corporation? Identify two different factors that affect stock price besides issuing new shares or repurchasing shares and how the price is affected?

Answer 1

ROE:-  If a company issues common shares during a particular period, the average equity would increase. This would mean a lower ROE, assuming that the net income stays the same.

ROA:- If a company issues common shares during a particular period, the average asset would increase due to increase in the cash inflow from issuance of new shares. This would mean a lower ROA, assuming that the net income stays the same.

P/E:- If a company issues common shares during a particular period, price and earnings per share, both of them would decrease. This is because an increase in the number of shares will decrease the earnings per share, which in turn will decrease the price of the share , causing a decline in P/e ratio. But if the new issuance is used to decrease the debt of the company, it will have positive effect on the share price because of the decrease in the risk of interest payment. This eventually leads to increase in p/e ratio . Therefore, the effect on p/e ratio due to new issuance depends on the motive for which it is issued and circumstances of the company. Hence we cannot determine the effect of new issuance on p/e ratio. But in general, p/e ratio increases with new issuance.

Factors affecting stock price

A) Interest rates:- In case of lower interest rates, demand for funds is higher and the subsequent demand for shares rises.This leads to increase in the price of the share .On the other hand, high interest lowers the demand for funds and the demand for shares is lower leading to decrease in share price.

B) Dividend:- Dividends indicate the movement of share prices. When companies make dividend announcements, the share prices of such companies are likely to increase. It is important to note that if the dividend rate announced is lower than the investors’ expectations, share prices decline while if they are up to more than expected, share prices increase.