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:
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.
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;