Question

Today, a Company’s Price to Earnings ratio (P/E Ratio) is 10.0x. P/E = Price per Share / Earnings per Share. Tomorrow, if new information comes out and becomes public that the product sales will triple, what do you think could be the P/E ratio tomorrow?

Answer 1

As there is no other information provided, lets assume along with sales, other expense will increase proportionaly. We can see this in a simple income statement below (with hypothetical values)

So As we know, that PE ratio is impacted by the EPS (Earnings per share) ratio which is further impacted by the net income. Taking the above example we see that the EPS is increased with the increasing net income. However the number of shares remains same so this will cause an impact on the PE ratio also.

But the PE ratio is dependent on the price of the share. Since a three-fold increase in sales will go as a positive news for the company in the market. As the investors expect a higher dividend from this company. And the investors will start putting more money on buying this company's shares, then it causes a demand-supply scenario where the demand is more than the supply. According to Fisher, investors raise expectations to unrealistic levels for companies that have periods of strong early growth. Also according to the fundamental theory of share price behaviour, share prices are determined by certain fundamental factors. These factors can be grouped as

1. Company-specific factors,
2. Industry-relevant information and
3. Macro-economic factors

In this case we are looking at point #1.At any point in time, any one factor or any combination of factors may affect the share price of a company. Based on these fundamental factors, each share has an intrinsic value.As the demand grows the share price will become overpriced. But how much stock price will rise that cannot be determined, but if the stock price rises more than 3 times of its current price then the PE ratio will definitely increase from its current value of 10X.However if the rise is less than 3 times, then PE ratio will see a decline despite three-folds sales increase.

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