Question

7) List the key variables that affect the P/E ratio and explain the relationship between each variable and the P/E ratio. (a) growth rate in earnings; the higher the growth rate, the higher the P/E ratio (b) general state of the economy, the better the economic outlook, the higher the P/E (e) amount of debt in a company's capital structure; the lower the debt ratio, the higher the P/E (d) current and projected rate of inflation; the lower the inflation, the higher the P/E (e) level of dividends, the lower the dividend payout, the higher the P/E Answer:

Answer 1

Ans. :-

(a.) Growth rate in Earnings :-

• Rate of earnings of a company directly affects the P/E ratio of the company.
• Here, The earnings refers to the Retained earnings of the company. That portion of the Earnings of the business which is re invested into the business for the purpose of expansion of business, to invest in other undertakings for better opportunity, for developing the business, or for any other purpose for the betterment and advancement of the business.
• Higher growth rate in the earnings of the company directly gets translated in the higher P/E Ratio.

(b.) General State of Economy :-

• Economic environment also might affect the P/E ratio.
• Favorable economic environment may increase the P/E ratio of the company. However, poor economy might cause fall in the P/E ratio.
• Hence, Better overall economic conditions cause higher P/E ratio.

(c.) Debt in company's capital structure :-

• Debt in the capital structure of the company and the P/E ratio of the company have Reverse relations.
• Higher portion of debt in the capital structure causes Lower P/E ratio.
• However, if the company's the capital structure comprise of less amount of Debt, then the company's P/E ratio tends to be higher.

(d.) Inflation rate :-

• Inflation causes fall in the P/E ratio of the company.
• Inflation reduces the value of the money hence it discourages the investors, which leads to the lower P/E ratio as well.
• Hence, Lower the Inflation rate, Higher the P/E ratio of the company.

(e.) Dividend payout ratio :-

• Dividend payout ratio also affects the P/E ratio.
• If company pays out higher portion of the earning as dividend and retains lesser amount in the business, then the P/E ratio of the company tends to be Lower.
• Whereas, Lower dividend payout ratio refers to higher retention ratio. So, if the company is having higher return on investment, then it should retain higher portion of earnings to achieve a higher P/E ratio.