(i) A P/E ratio is the ratio of the market value of a share to earnings per share: it is often
described as the number of years earnings required before an investor recovers the
purchase price of a share (on the assumption that annual earnings are constant). The
earnings of a company with a high P/E ratio are therefore valued more by investors
because they are prepared to wait more years to recover their investment. A high P/E
ratio therefore tends to indicate that a company is somehow „more secure?. Thus:
A well-established company is likely to have a higher P/E ratio than a company
which is newly-quoted on the stock exchange;
A large company with a bigger asset backing is likely to have a higher P/E ratio than
a small company with smaller asset base – because assets are regarded as a last resort
security in the event of a winding up;
A company may suffer a temporary fall in profits and if investors expect profits to
recover, they may be prepared to pay more for a share than current performance
would justify - i.e. the P/E ratio may be temporary high;
Investors may expect a company to grow considerably in the next few years, and in
anticipation of growth, will pay a higher price for shares now. A company with
growth prospects should therefore have a higher P/E ratio than companies where no
growth is expected.
Dividend policy affects share prices as much, if not more, than earnings retention
rate may therefore have a higher P/E ratio than a company with the same volume of
earnings but which pays a lower dividend. Dividend cover may therefore influence
the P/E ratio.
marto answered the question on February 11, 2019 at 11:18
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