Question

When a firm with an extremely high price/earnings ratio purchases a firm with a very low price/ earnings ratio in an exchange of stock, its earnings per share will increase. Do you think firms are more likely to acquire other firms when it results in an increase in their earnings per share? Is it beneficial to shareholders to initiate a takeover for these reasons?

Answer 1

When it comes to valuing stocks, the P/E ratio is one of the most frequently used multiple.A price to earnings or P/E ratio is used to evaluate how expensive or cheap, the stock may be at any given time.

Companies with a low Price Earnings Ratio are often considered to be value stocks. It means they are undervalued because their stock price trade lower relative to its fundamentals.And when it does, investors make a profit as a result of a higher stock price.

Companies with a high Price Earnings Ratio are often considered to be growth stocks. This indicates a positive future performance, and investors have higher expectations for future earnings growth and are willing to pay more for them. The downside to this is that growth stocks are often higher in volatility and this puts a lot of pressure on companies to do more to justify their higher valuation. For this reason, investing in growth stocks will more likely to be seen as a risky investment. Stocks with high P/E ratios can also be considered overvalued.

However, this doesn’t mean that stocks with high P/E ratios cannot turn out to be good investments.

Lets Take an Example:- There are two Stocks, Stock A trading at $40 per share with an EPS of $2 would have a P/E ratio of 20 ($40 divided by $2) and Stock B Trading at $40 per share with an EPS of $1 would have a P/E ratio of 40 ($40 divided by $2).Which means if the investor decided to go for Stock B he would be paying $40 to claim a mere $1 of earnings. This seems like a bad deal, but there are several factors that could mitigate this apparent overpricing problem:-

First, the company could be expected to grow revenues and earnings much more quickly in the future than companies with a P/E of 20, thus commanding a higher price today for the higher future earnings.

Second, suppose the estimated (trailing) earnings of the 40-P/E company are very certain to materialize, whereas the 20-P/E company’s future earnings are somewhat uncertain, indicating a higher investment risk.

Investors would incur less risk by investing in more-certain earnings instead of less-certain ones, so the company producing those sure earnings again commands a higher price today.

Hence, to conclude one must consider what premium he is paying for a company’s earnings today and determine if the expected growth warrants the premium. Also, compare the company to its industry peers to see its relative valuation to determine whether the premium is worth the cost of the investment.