Question

A firm with a high level of growth opportunities is most apt to have a:

A) high PE ratio and a high EV multiple.

B) high cash ratio and a low EV multiple.

C) high PE ratio and a low EV multiple.

D) low PE ratio and a high EV multiple.

E) low cash ratio and a low PE ratio.

Answer 1

P/E ratio is the ratio of the market price of shares per unit of earnings. The market price of the stock takes into consideration of all the future growth potential. Therefore the firm with a high level of growth opportunity is expected to have a higher P/E ratio.

EV multiples are EV/EBITDA, EV/EBIT etc. EV is the enterprise value of the firm which is the sum of the market value of equity and debt. EBITDA and EBIT are the indicators of the financial performance of a company in a particular year. Since EV includes the market value of the equity which is higher for a higher growth stock, therefore the EV will be higher for a higher growth stock. Hence the EV multiple will also be higher for higher growth firms.

Thus for higher growth firms, both P/E and EV multiples are expected to be higher.

Hence the option (A) is the answer.