EXTERNAL FACTORS THAT INFLUENCE THE PRICE/EARNINGS RATIO
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A firm?s earnings and its stock price determine the
price/earnings ratio. However, the meaning of a P/E ratio can be distorted by
factors outside the control of the individual firm. While these factors affect
the market as a whole, they may not affect the performance of an individual
firm. These external factors can be categorized as the following:
factors (inflation, interest rates, federal deficits, etc.). These factors
generally alter the price that investors are willing to pay for a given stock.
Since these factors are temporary in nature, the resulting stock price and P/E
ratio need to be viewed with this in mind.
Industry factors (cyclical industries). The cyclical
nature of some industries can generate misleading P/E ratios. For example, a
company that is in an industry experiencing a temporary recession can be a good
investment despite the fact that it may have an inflated P/E due to poor current
earnings. Since financial publications will publish a P/E ratio based on a
firm?s earnings over the last 12 months, if an industry has been in a recession
for the last 12 months, the P/E ratio may be deceivingly high.
Emotional factors or investor confidence. No other factor
is so difficult to predict. In moments of irrational exuberance, investors can
bid up the prices of stocks, thus making their P/E ratios much higher than they
would normally be. The reverse is also true. During periods of extreme pessimism
or panic, investors will sell, driving down the prices of stocks. In this case,
a firm?s P/E ratio could be understated, making it appear to be an attractive
buy when in fact it might not be.
These are some of the factors that can temporarily affect the
entire market or specific industries. These factors are outside the control of
the firm and can distort the true meaning of the P/E ratio. You should always be
aware of these factors when analyzing P/E ratios.
In addition to external factors, many internal factors can
influence or distort the P/E ratio. We?ll discuss these factors