Bob Brinker's Marketimer

  Tuesday November 21, 2017

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EXTERNAL FACTORS THAT INFLUENCE THE PRICE/EARNINGS RATIO
Learn even more about this topic with the Encyclopedia of Personal Finance™

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:

Macroeconomic 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 next.




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