Business Finance

Executive Summary of Business Finance

The price earnings ratio helps the investors in determining the effective value of the company in the market. It shows the market expectations and indicates the price that must be paid per unit of current or future earnings. Different companies carrying out similar kind of operations within the industry can be grouped together to draw comparison irrespective of the differences in their stock prices. It has been analysed that the companies having lower P/E ratio shows that company’s stocks are undervalued currently or they may do well in the future in comparison to past trends. The investors are advised to use it in combination with other various type of valuation methods and not as a sole method for undertaking investment in the business organization.

Introduction to Business Finance

The price earnings ratio indicates the relationship between the stock price of the company and the earning per share. This ratio helps the investors in determining the effective value of the company in the market. It shows the market expectations and indicates the price that must be paid per unit of current or future earnings. This ratio is considered important while valuing the stock of the company because investors have a desire to estimate the profitability of the company in the current situation and also the future growth prospects (Sunartiyo, 2018). Investors always wanted to invest in financially sound companies that will provide them with an effective return on investment. The price earnings ratio is considered as the part of research process for choosing stocks among the many available ratios because it helps in figuring out whether the investors are paying the fair price for the stock or not. Different companies carrying out similar kind of operations within the industry can be grouped together to draw comparison irrespective of the differences in their stock prices. However, companies having lower price to earnings ratio are considered to be as valuable stocks. In this report, this ratio will be critically examined for share valuation.

Analysis of Price to Earnings Ratio

Price to earnings ratio is widely used by the investors to value the stock. High level of P/E ratio show that the investors have expectations that the earnings of the company would grow at a faster rate as compared to the companies having lower P/E ratio. Whereas, the companies having lower P/E ratio shows that company’s stocks are undervalued currently or they may do well in the future in comparison to past trends. Higher P/E ratio generally means that the price of the company’s stock is expensive whereas lower P/E ratio means that the share price is low (Kumar & Venoor, 2018). This ratio is easy to understand and can be used effectively for valuing stock of the company. It helps in drawing comparison between the stocks of different companies. Performance of the company can be easily tracked across the specified time period by estimating the price to earnings ratio.

However, this ratio cannot be used effectively in case of growth stocks such as in case of technology based companies (Arkan, 2016). Companies having high P/E ratio are normally considered to be growth stocks. This shows that positive performance in future period and investors have high expectations with regard to the growth in future earnings and are therefore, ready to pay higher prices for them. The other side to this is that growth stocks are highly volatile and puts a large pressure on the companies to achieve more in order to justify high level of valuation. This is the reason that the investment in growth stocks is considered as a highly risky investment. Shares having high P/E ratio can also be regarded as overvalued. The P/E ratios for different companies can only be compared if those companies are operating within the same industry.

Limitations in Using PE Ratio to Value Share

There are a number of issues in using the P/E ratio for valuing stocks. The major issue is that it does not consider any kind of growth or the deficiency of it. Also, the companies that have raised funds using debt capital sources are meant to have high risk investments but the price in price earnings ratio only considers the price of equity and do not take into account the debt amount that has been incurred by the business organization. The earnings that are considered in price to earnings ratio are accounting earnings as are referred in accounting standards meant for specified country and not the cash earnings of the business enterprise (Zhong & Li, 2017). It is considered extremely difficult for the investors to estimate the earnings of the company after 10 years that are being listed on stock exchange for a period of one year or two. The earnings of the company can significantly rise or go downwards over the period of 10 years.

It is suggested for the investors to own the shares of those companies whose earnings will rise continuously over the period of next 10 years instead of applying for shares in companies whose earnings might go down significantly. Price to earnings ratio does not indicate what will exactly happen to the share performance in the future period. It indicates nothing with regard to the balance sheet of the company. There can be a case where the company is trading on 3 times P/E multiple is actually expensive as the company might have a large amount of long term and short term debt and have no way of paying of the debt amount and subsequently, it may be declared bankrupt due to its performance in the current financial year (Dennison, 2018). Moreover, this ratio does not indicate regarding the quality of earnings of the company. However, price to earnings ratio is still considered as a good ratio that helps in valuing the stocks of the company but the investors are advised to use it in combination with other various type of valuation methods and not as a sole method for undertaking investment in the business organization.

Higher Stock Price Reinforces Agency Incentives

The agency problem is concerned with conflicting interest between the management of the company and its stockholders. The management of the company who is acting on behalf of shareholders or the principals, is required to act in their best interests and undertake decisions that will maximize their returns (Heminway, 2017). The conflict of interest arises when different parties have dissimilar interests. Issues occur when the agents start serving their own interest. Therefore, conflict arises between the interests of principals and agents when both the parties have distinct motivations of incentives that have the capacity to place these parties at odds. Companies may use various techniques to resolve such kind of issues like contractual incentives, monitoring, etc. These problems can be lessened with the help of right incentives and designing of contract. In case when the agents are performing in their own interests, incentives can be changed to redirect their interests that might be proved beneficial for the shareholders.

Companies’ executives are basically concerned about the value that is being attached to the stock by the market to their companies as the stock market price is used by the investors and security analysts to assess the performance of the management. The economic interest of the management is also connected with the stock price to the level that their own wealth is invested in the stock of the company and in various stock options (Gomez-Mejia et al., 2019). Also, stock price can influence the cost of capital of the company. This is the reason top executives are also concerned about the stock price. It has been found that stock ownership by management of the company not only helps in persuading the executives to determine economic interests of shareholders but also helps in fascinating long-term incentives.

Conclusion on Business Finance

It can be concluded that the price earnings ratio is considered as the part of research process for choosing stocks among the many available ratios because it helps in figuring out whether the investors are paying the fair price for the stock or not. Investors always wanted to invest in financially sound companies that will provide them with an effective return on investment. This ratio cannot be used effectively in case of growth stocks such as in case of technology based companies as growth stocks are highly volatile and puts a large pressure on the companies to achieve more in order to justify high level of valuation. This is the reason that the investment in growth stocks is considered as a highly risky investment. Shares having high P/E ratio can also be regarded as overvalued. The P/E ratios for different companies can only be compared if those companies are operating within the same industry. Price to earnings ratio does not indicate what will exactly happen to the share performance in the future period. It indicates nothing with regard to the balance sheet of the company. Companies may use several techniques to resolve issues arising with regard to agency problem like contractual incentives, monitoring, etc. These problems can be lessened with the help of right incentives and designing of contract.

References for Business Finance

Arkan, T. (2016). The importance of financial ratios in predicting stock price trends: A case study in emerging markets. Finanse, Rynki Finansowe, Ubezpieczenia, (79), 13-26.

Dennison, T. (2018). Equities and Stock Markets. In Invest Outside the Box (pp. 75-88). Palgrave Macmillan, Singapore.

Gomez-Mejia, L. R., Neacsu, I., & Martin, G. (2019). CEO risk-taking and socioemotional wealth: The behavioral agency model, family control, and CEO option wealth. Journal of Management45(4), 1713-1738.

Heminway, J. M. (2017). Shareholder wealth maximization as a function of statutes, decisional law, and organic documents. Wash. & Lee L. Rev.74, 939.

Kumar, S., & Venoor, M. A. (2018). Analysis of impact of earning per share, dividend per share and price earnings ratio on stock performance. International Journal of Research in Economics and Social Sciences (IJRESS)8(3).

Sunartiyo, T. (2018). Effect of Inflation, Earning Per Share (EPS), Price Earnings Ratio (PER) on Stock Price PT. Siantar Top, Tbk. International Journal of Business and Applied Social Science (IJBASS)4(9).

Zhong, Y., & Li, W. (2017). Accounting conservatism: A literature review. Australian Accounting Review27(2), 195-213.

Remember, at the center of any academic work, lies clarity and evidence. Should you need further assistance, do look up to our Accounting and Finance Assignment Help

Get It Done! Today

Applicable Time Zone is AEST [Sydney, NSW] (GMT+11)
Not Specific >5000
  • 1,212,718Orders

  • 4.9/5Rating

  • 5,063Experts

"

5 Stars to their Experts for my Assignment Assistance.

There experts have good understanding and knowledge of university guidelines. So, its better if you take their Assistance rather than doing the assignments on your own.

What you will benefit from their service -

I saved my Time (which I utilized for my exam studies) & Money, and my grades were HD (better than my last assignments done by me)

What you will lose using this service -

Absolutely nothing.

Unfortunately, i had only 36 hours to complete my assignment when I realized that it's better to focus on exams and pass this to some experts, and then I came across this website.

Kudos Guys!

Jacob

"

Highlights

  • 21 Step Quality Check
  • 2000+ Ph.D Experts
  • Live Expert Sessions
  • Dedicated App
  • Earn while you Learn with us
  • Confidentiality Agreement
  • Money Back Guarantee
  • Customer Feedback

Just Pay for your Assignment

  • Turnitin Report

    $10.00
  • Proofreading and Editing

    $9.00Per Page
  • Consultation with Expert

    $35.00Per Hour
  • Live Session 1-on-1

    $40.00Per 30 min.
  • Quality Check

    $25.00
  • Total

    Free
  • Let's Start

Get
500 Words Free
on your assignment today

Browse across 1 Million Assignment Samples for Free

Explore MASS
Order Now

Request Callback

Tap to ChatGet instant assignment help

Get 500 Words FREE
Ask your Question
Need Assistance on your
existing assignment order?