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Learning Objectives

4. Calculate the yields on financial claims based on the relationship between current price and future expected cash flows. (LO4)

5. Describe the use of a price-earnings ratio to determine value. (LO5)

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Valuation Using the Price-Earnings Ratio

The Price-Earnings (P/E) ratio can also be used to value stocks

The P/E ratio is influenced by:– the earnings and sales growth of the firm

– the risk (or volatility in performance)

– the debt-equity structure of the firm

– the dividend policy

– the quality of management

– a number of other factors

In May 2011, the average P/E for the top 300 companies of the Toronto Stock Exchange was 20 to 1.

LO5

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High versus Low P/EsA stock with a high P/E ratio:

– indicates positive expectations for the future of the company

– means the stock is more expensive relative to earnings

– typically represents a successful and fast-growing company

– is called a growth stock

A stock with a low P/E ratio:

– indicates negative expectations for the future of the company

– may suggest that the stock is a better value or buy

– is called a value stock

LO5