Q. Evaluate Price Earnings Ratio?
The P/E ratio is in general regarded as an important ratio for equity investors. The P/E for a company may be utilizing as a basis for comparison with other companies especially in the same business sector. A P/E ratio is able to be described as an indicator of potential earnings. Higher The P/E ratio higher the future expectations in terms of earnings growth. Earnings potential is determined extremely much by the sector of business and so the P/E ratio of any single company should simply be used for intra sector comparisons and not cross sector comparison.
The P/E ratio as well reflects the level of financial risk in the company because the share price will be adjusted to compensate for such risk. By means of the information in the table the P/E ratio for Ply is 14·2 which signifies that if an investor were to purchase shares in the business then based on current earnings it would take over 14·2 years before the cumulative earnings per share equalled the price paid for the share (if there was no earnings growth). By mode of contrast the P/E for Spin is 21·1.
The P/E ratio is used since already suggested to indicate growth potential and so the higher figure of 21·1 for Spin indicates that the market believes that the company has a greater chance of increasing its profits and earnings per share than does Ply. The cause for the different potential may lie in a different investment strategy, better quality management or better investment opportunities. The P/E ratio merely indicates the market's explicit recognition of that potential.
The P/E ratio thus changes in response to announcements which affect a company's share price. Suppose for instance ply were to announce that its quarterly sales figures had grown much quicker than expected then the price of the share might rise in response. The P/E ratios relay the earnings for the last financial year to the current share price and since the P/E is based on last year's earnings (which are unchanged) the higher share price results in a higher P/E ratio. In other sense the market is now more confident about the company's future.
This can be exemplify as follows
Share price 1st December 2000 is 63 cents EPS 4·44 cents P/E ratio 14·2
On 5th December 2000 the company announces a 15% sales increase over the last quarter and the share price rises to 70 cents in response.
New P/E ratio = 70/4·44 = 15·77
Such price changes signify that a P/E ratio can vary quite substantially over the course of the year. For Ply if the P/E ratio is 14·2 at a price of 63 cents then at the year's highest price of 112 the P/E would be 25·2 and at the 52 week low price of 54 it would be 12·2. The range for the ratio is therefore quite wide over the course of the year. Alike ranges could be calculated for the other two companies for the purposes of comparison.
From the concise information in the table, the market would appear to be most confident about the future earnings potential of Spin, and least confident about Axis. Spin has the uppermost current P/E ratio and the least volatile share price whilst Axis is the reverse. The investor can consequently use information on P/E ratios to identify high growth companies in which they may wish to invest because of their long-term capital growth potential.