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Good day,
I saw in a solution to a question that PE Ratio for company A is 13.0(meaning it would take A 13years for the earnings from the share to equal the price paid for it), while that of company B is 21.1(as it would take B 21.1 years for the earnings from the share to equal the price paid for it).
My confusion started when its said that investors expect earnings from B to rise faster than that of A.
I’m so confused about this, please I’d appreciate more explanations.
Thank you.In your example, why would anyone ever buy share B if it was going to take 21.1 years to get their money back? They could buy share A and get their money back sooner!!
The amount you will be prepared to pay for a share depends on what you expect in the future.
My company may have been earning $100 a year every year in the past. Suppose that you expected it would continue to make $100 a year in the future and that you were prepared to pay $1000. It would have a PE of 10 (1,000/100)Suppose however, you thought that the future earnings were going to in fact be a lot higher that $100 a year – that it was going to grow a lot.
Surely, you would then be prepared to pay more that $1,000. Let’s say you were prepared to pay $1,500.The PE is calculated using the latest earning and so would now be 1500/100 = 15.
Why is the PE higher? Simply because you are expected higher earnings in the future.
The higher growth you expect in the future, the more you would pay for the share, therefore the higher the PE ratio.
Hmmnn! Thank you for that eye opener. It just suddenly got a lot easier. It explains why investors can rely on Company B. Thank you.
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