Question

section 2.3 financial literacy
objective 1 - understand pe ratios and stock quotes
objective 2 - understand inflation and the cpi
objective 3 - compute money ratios for retirement
objective 1 - understand pe ratios and stock quotes
guided practice activity #9 - pe ratios
the price to earnings, or pe ratio, is one of the most common statistics used to assess the
value of a share of stock. stocks will be fully discussed in chapter 9, but for now we want to
introduce the basic idea of the pe ratio.
share price $28.40 (price to
buy 1 share of this stock)
at&t inc (nyse: t)
price
change
time
28.40
+0.17 +0.6%
1/21/2011, 2:53 pm est
volume:
8,085,378
days range:
28.23 - 28.48
52 wk range:
23.78 - 30.10
1 yr% change:
+10.66
beta:
0.66
price/earnings:
8.0x
earnings per share
3.55
dividend & yield:
1.72 (6.06%)
pe ratio, 8.0, share price :
earnings per share
earnings per share, $3.55...

1. the share price changes constantly as people trade shares with each other. if there are more

buyers than sellers, the price goes up. if there are more sellers than buyers the share price
goes down. what are two different ways the pe ratio can increase?

Explanation:

Step1: Recall the formula for PE ratio

The formula for the Price - Earnings (PE) ratio is \(PE=\frac{\text{Share Price}}{\text{Earnings per Share}}\).

Step2: Analyze the effect of share price increase

If the earnings per share remains constant, an increase in the share price will cause the PE ratio to increase. For example, if \(Earnings\ per\ Share = 3.55\) (constant) and \(Share\ Price\) increases from \(28.40\) to \(35.5\), then \(PE\) ratio changes from \(\frac{28.40}{3.55}=8\) to \(\frac{35.5}{3.55} = 10\).

Step3: Analyze the effect of earnings per share decrease

If the share price remains constant, a decrease in the earnings per share will cause the PE ratio to increase. For example, if \(Share\ Price=28.40\) (constant) and \(Earnings\ per\ Share\) decreases from \(3.55\) to \(2.84\), then \(PE\) ratio changes from \(\frac{28.40}{3.55}=8\) to \(\frac{28.40}{2.84}=10\).

Answer:

The PE ratio can increase in two ways:

1. When the share price increases while the earnings per share remain constant.
2. When the earnings per share decrease while the share price remains constant.