Price-Earning Ratios and Profit Performance - Coursework Example

INTRODUCTION This report provides a discussion on the possible factors that can influence the price-earning ratio of a company's shares. As the ratio itself depends upon various other factors, therefore, all these factors can either lead the ratio to reach the highest or the lowest level. The P/E analysis in this report is done on the five leading companies from retailing sectors having different P/E ratios. This variation in ratios has been analysed with the help of various factors that can affect the calculation and interpretation of the ratio. PART -1 DIFFERENCES IN PRICE-TO-EARNINGS RATIO Company Name P/E Ratios Boots 19.9 JB Sports 9.4 Marks and Spencer 13.4 Morrison 47.2 Tesco 17.2 As said by Flamholtz (1986, p655), "The price-earnings (P-E) ratio measures the relationship of the market price of a firm's common stock to its earnings per share", the P/E ratio is a measure of analysing a company's market position and investors trust that is reflected in the market price of its shares. The higher the price-earnings ratio, the higher the growth potential the company has in the view of its investors. It reveals the market worth of a company's shares and explains how expensive the shares are in relation to the earnings obtained on the shares. For instance, two different companies have the same level of net profit but one company has a lower Price-earnings ratio, it would reflect that its shares are cheaper than the other company. From the above chart also, the P/E ratios of five companies can easily be spotted. All these companies are from the same industry and are among the most popular companies in the retail sector. As reflected by above price-earning ratios, these companies have a varying range of ratios as at February 8, 2006. The price-earning ratio is calculated by dividing a company's market price with the earnings per share and therefore, the price-earning ratio of a company depends upon several factors that are responsible to keep it at a lower or higher level. The determinants of a company's P/E ratio force the company's market price to fluctuate, which is followed by a fluctuation in the ratio. Some of the major determinants causing variation in different companies' price-earnings ratios are discussed below: Growth Potential Brealey and Meyers (1984) suggest that a company's high price-earning ratio reflects that the investors have more confidence in the company's future growth potential. It shows that the expectation of a company's future growth also has a great impact on its price-earning ratio. It is true that investors do have a keen eye on various companies' financial position and performance so that they can also benefit with a company who is climbing the high ladders of growth and profitability. If the company is growing, it will have more profit to be forwarded to the shareholders. Therefore when the investors believe in a company's future performance, they will be willing to invest more in the company's shares leading to a significant rise in the stock value followed by an increase in the P/E ratio. The chart displaying the price-earning ratios of the companies from same industry reveals that the company with a high P/E ratio i.e., Morrison plc with a P/E ratio of 47.2, has more future growth prospects in the eyes of its investors and shareholders than the other companies in the industry i.e., Boots, Tesco, Marks and Spencer and JB Sports plc. This is because the investors mostly look for benchmarking a company's performance and potential with the other companies in industry standing at the same level and once they find a company with better prospects, they invest more of their funds in the company's shares. Hence, it can be said that the element of growth potential is one of the major causes underlying the differences between the above companies' price-earning ratios. Net Profit Smith and Skousen (1987) suggest that an increase or decrease in a company's price-earning ratio is the resultant of its profitability. It indicates that more a company is profitable; the more the investors would be induced to invest in its shares. Whenever the investors figure out that a listed company is sustaining profitability and has a stable increase in profits, they invest their funds in that company, which lead to an increase in the price-earnings ratio. This will have a double effect on the company, firstly it will get more equity funds for the company and secondly it will have a positive impact on the market value of the company's shares. The calculation of price-earning ratio depends a lot on the profits earned by the company in consideration and if the profit is declining, the P/E is supposed to fall. Same is the case with the above five retailing companies. Morrison plc is having a higher P/E ratio (i.e., 47.2) than the rest of the retailing companies. The second higher price-earning ratio is Boots plc with 19.9, then Tesco with 17.2, followed by Marks and Spencer 13.4, and finally the JB Sports with the lowest price-earning ratio of 9.4. It reflects that of all the five companies, the investors rank Morrison plc as the most profitable company and therefore buy more of its shares, increasing their market prices. On the contrary, the income prospects of JB Sports are supposed to be lower than all these companies as reflected by the P/E ratio and thus, the investors withdraw their investment in the company leading to a fall in the market value of its shares. The other aspect of this analysis is that the increasing net profit has led the P/E ratio of Morrison plc to be the highest, whereas the declining profit of JB Sports has caused the P/E ratio to remain at the lowest point. In other words, the high profits lead to higher P/E ratio and low profits lead to lower P/E ratio. Therefore, it can be said that the major cause of the difference in price-earning ratio of the five retailing companies can be the level of profit they are earning influencing the calculation of the ratio. Earnings Per Share Flamholtz (1986, p654-655) suggests that the purpose of earnings per share is "to provide the shareholders with a comparative figure of the earnings of the company on a per share basis". It shows how important a company's EPS is for the investors. As Smith and Skousen (1987) suggest that the investors are the most concerned with a company's earnings in relation to the market price of its shares. Therefore, the investors greatly consider the earning per share ratio of a company when making their investment decision and the companies having higher EPS tend to have a higher P/E ratio. Other than that, the calculation of price-earning ratio greatly depends upon the earning-per-share of the company and any increase or decrease in EPS can lead to great fluctuations in the ratio. Earning per share can also be a major cause of difference between the above companies' P/E ratios as explained above. For instance, the highest price-earning ratio of Morrison plc exhibits that the company has a higher earning per share as compared to the other companies it is compared with. The lowest P/E ratio of JB Sports, on the other hand, indicates that the company has a smaller EPS than the rest of the companies. Therefore, it can be said that the earning per share of a company has a great impact on the price-earning ratio of a company and hence, it can serve to be the major cause of difference in the P/E ratios of the above-mentioned companies. Market Price Per Share According to Flamholtz (1986, p655), "a firm's P-E ratio fluctuates daily with the change in the price of the firm's stock". This reflects that the stock price of a company's shares has a great influence on its price-earning ratio. The P/E ratio is calculated on the basis of dividing a company's current market price with the earning per share of the company. Therefore, any fluctuation in the market price of a company's shares greatly influences the price-earning ratio of the company. The market price of a company's shares rises when the investors are keener to purchase its shares irrespective of their price due to any favourable future trends. On the other hand, it declines when the investors tend to sell out the company's shares and withdraw their investment in the company. Hence, if the market price of a company's stock rises, the P/E ratio will go up and if the market price declines, the P/E ratio will fall down. This is because it is said that the price-earning ratio reflects the perception of a company's growth in the eyes of investors. Therefore, if a company has a higher price of its share in the market, it is supposed to have a higher price-earning ratio than the other companies in the same industry with lower share price in the market. It suggests that the reason behind the highest P/E ratio of Morrison plc can be that it had a higher market price at the time when the ratio was calculated, as the price-earning ratio is always calculated on the current market price of a company's shares. Likewise, the lowest P/E ratio of JB Sports plc reflects that the company might have had a lower market price of its share than the other companies in retail industry at the specific point in time when the ratio was calculated. Whatever the case might have been, any fluctuation in the stock price can affect the P/E ratio of a company and therefore it can be said that the discrepancies between the P/E ratios of the above discussed five companies in retail industry could have been brought about by the stock price fluctuation. PART -2 FALLING PRICE-EARNING RATIO OF ELGIN ELECTRONICS An analysis of the information provided in the case suggests that a decline in price-earning ratio of the company over the last three years despite the stable profitability performance of the company may be a resultant of poor investor expectation regarding the growth potential of the company. This might have forced the investors and shareholders to sell off the company's shares and withdraw their investment in the company's stock. Although the company still remains above the industrial average and the declining P/E ratio does not affect its profitability and performance, but it needs to consider the factors that are causing a drastic change in the P/E ratio, mainly the falling market price in this case. The falling market price can affect the company's reputation and may further serve to reduce investor confidence. CONCLUSION The above analysis shows that there happen to be several factors that determine the P/E ratio of a company. When a company has a higher P/E ratio than its competitors, it can be said that there might be a lot of factors directly influencing the ratio i.e., the company's growth potential, profitability, EPS, market price per share etc. Price-earning ratio is the reflector of a company's position and prospects in the eyes of investors. It therefore implies that there needs a keen attention on the calculation and interpretation of the price-earning ratio, as there could be many hidden factors that could be utilised by the companies in order to deceive the investors. References Brealey, Richard, and Myers S. (1984), "Principles of Corporate Finance", McGraw-Hill Book Company Flamholtz, Diane T. (1986), "Financial Accounting", Boston, MA: PWS-KENT Publishing Co., p654-655 Smith, Jay M., Jr., and Skousen Fred K. (1987), "Intermediate Accounting", South-Western Publishing Co. 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