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  Monday November 20, 2017

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INTERNAL FACTORS THAT INFLUENCE THE PRICE/EARNINGS RATIO
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Several factors within a firm?s control influence the price/earnings ratio. They affect the ratio either by influencing earnings or the market price of stock. Since the market value of a stock is more arbitrary, factors affecting the price tend to have greater influence on the P/E ratio than factors that affect earnings. Let?s briefly discuss some of these factors:

Future growth potential is one of the biggest determinants of a stock?s price. A firm that expects to have high future growth in earnings will have a high stock price in relation to its current earnings. Investors will pay a premium for a high-growth stock today in expectation of larger dividends or capital gains in the future. This firm will consequently have a high P/E ratio.

A firm?s debt-to-equity ratio is another factor that influences the stock price and therefore the P/E ratio. A firm with a small amount of debt will be valued higher in the market than if it had a large amount of debt. In this case, its stock?s P/E ratio would be higher due to its higher price.

The quality of a firm?s management can also influence the price of a stock. Investors who think a company has high-quality managers will be willing to pay a premium for its stock because they believe these managers will deliver earnings growth in the future. Their faith in management results in a stock price valuation greater than its earnings and growth rate would otherwise indicate.

The quality of earnings is largely a measure of a firm?s accounting methods. Income statements can be manipulated to a certain extent in order to report either higher or lower net earnings. If a firm uses sound, conservative accounting practices, the quality of earnings is deemed high. Firms with a high quality of earnings generally have higher P/E ratios.

All of these internal factors have significant influence on the price/earnings ratio. For an investor, it is very important to understand how all of these factors intermingle to produce the all-important P/E ratio.




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