Question

One of the consequences of the economic meltdown in 2008 was a free fall of the stock market’s average PE ratio. A PE ratio is the price per share divided by the earnings per share. This ratio measures how much investors are willing to pay per dollar of current earnings. An analyst wants to determine if the PE ratio of firms in the footware industry are different from the overall average of 14.9 in 2010. The analysts takes a sample of seven footware industry firms.

1. a) Higher PE ratios typically mean a firm has significant prospects for future growth. When could a

   high PE ratio be misleading? (Hint: ?? ????? = ????? ??? ????? / earnings per share)

data:

Firm	P/E Ratio
Brown Shoe Co., Inc.	20.54
Collective Brands, Inc.	9.33
Crocs, Inc.	22.63
DSW, Inc.	14.42
Nike, Inc.	18.68
Skechers USA, Inc.	9.35
Timberland Co.	14.93

Answer 1

Generally a high price earning ratio suggests that investors are expecting higher growth rate in the future from these companies. The ratio indicates the dollar amount that an investor can expect to invest in a company to receive a dollar of that companies earnings.

The major reason that the price earning ratio is considered misleading is that it it is based upon past data and there is no guarantee that the earnings will continue in the future. If the ratio is based upon projected earnings there is a risk that the estimates will not be accurate.

Moreover a high price earning ratio maybe because the price of the stock is overvalued. In certain years the earnings may be under valued due to high depreciation and high interest expenses boosting the price earning ratio and thus misleading the investors.