Calculate the Industry Simple Average Price-Earning(pe) Ratio

Business Finance assignment

Calculate the industry simple average price-earning(PE) ratio

For each company:

Price-Earning(PE) ratio= Stock price ÷ Earnings per share (EPS)

Therefore,

For the industry:

industry simple average price-earnings (PE) ratio= Sum of PE ratio of all companies in industry ÷ Number of companies in industry

Therefore,

industry simple average price-earnings (PE) ratio= (18.5244+9.4621+20.7692) ÷ 3=16.2519

Calculate Ragan’s stock price

EPS= (Net income - Dividends on Preferred Stock) ÷ Average outstanding shares

Because Ragan Thermal Systems is a privately owned company and equally owned by a couple and the couple owns 50,000 shares each, Dividends on Preferred Stock=0 and Average outstanding shares=100,000.

Thus,

EPS of Ragan Thermal Systems= ($320,000 - 0) ÷ 100,000= $3.2

Use the industry’s benchmark PE,

Ragan’s stock price= Industry’s benchmark PE × EPS of Ragan Thermal Systems

                               = 16.2519 × $3.2 = 52.0061

“Caution is warranted when using PE ratio to value stocks.”

This statement is right.

Firstly, let’s have a look at the definition of PE ratio.

The price-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (“Price-Earnings Ratio - P/E Ratio”, n.d.). Therefore, it actually means that the amount of dollars that investors should invest in order to get one dollar from that company.

There are several advantages by using the PE ratio to value stocks.

        1.        The most significant advantages of PE ratio is that it is easy to understand even for those who are not educate in finance.

        2.        Compare to only focusing on the stock prices, the PE ratio is more indicative(Csanad, 2013).

        3.        The PE ratio can indicate the performance of the company(Csanad, 2013). For example, if the PE ratio tend to be constant but the EPS of the company is increasing. Then investor should buy the stocks of the company.

Therefore, the PE ratio is a quick and good way to value stocks.

However, there are still several drawbacks that require investors to be cautious when making the decision.

        1.        Different industries have different PE ratio ranges (Kennon, 2017). For instance, Software companies usually have larger PE ratios because they have much higher growth rates and earn higher returns on equity. Therefore, investors should use more methods when comparing stocks from different industries.

        2.        The PE ration does not take any type of growths into consideration (Smith, 2009).