Multiple Choice
Which of the following formulas is used to estimate a stock's price based on the benchmark Price-Earnings (PE) ratio?
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14. Financial Statement Analysis
Ratios: Price-Earnings Ratio (PE Ratio)
Multiple Choice
Which one of the following statements is true concerning the price-earnings (PE) ratio?
A
A higher PE ratio always indicates a company is undervalued.
B
The PE ratio measures a company's ability to pay its short-term liabilities.
C
The PE ratio is calculated by dividing the market price per share by the earnings per share (EPS).
D
The PE ratio is calculated by dividing earnings per share by the market price per share.
Verified step by step guidance1
Step 1: Understand the concept of the Price-Earnings (PE) ratio. The PE ratio is a financial metric used to evaluate the valuation of a company by comparing its market price per share to its earnings per share (EPS). It helps investors assess whether a stock is overvalued or undervalued relative to its earnings.
Step 2: Clarify the formula for calculating the PE ratio. The correct formula is: . This means dividing the market price per share by the earnings per share.
Step 3: Analyze the statements provided in the problem. For example, the statement 'A higher PE ratio always indicates a company is undervalued' is incorrect because a higher PE ratio typically suggests that investors expect higher growth, but it does not necessarily mean the company is undervalued.
Step 4: Evaluate the statement 'The PE ratio measures a company's ability to pay its short-term liabilities.' This is incorrect because the PE ratio is not related to liquidity or short-term liabilities; it is a valuation metric.
Step 5: Confirm the correct statement: 'The PE ratio is calculated by dividing the market price per share by the earnings per share (EPS).' This aligns with the formula and definition of the PE ratio, making it the correct answer.
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