Which of the following is a correct interpretation of a Price-Earnings (P/E) ratio?

• A. It indicates the proportion of a company's assets financed by debt.
• B. It measures the percentage of earnings paid out as dividends to shareholders.
• C. It shows how much investors are willing to pay per dollar of a company's earnings.
• D. It represents the company's net income divided by its total assets.

Answer: (C)

Verified step by step guidance

1. Step 1: Understand the concept of the Price-Earnings (P/E) ratio. The P/E ratio is a financial metric used to evaluate the valuation of a company by comparing its current share price to its earnings per share (EPS). It is calculated as: P/E Ratio = Price per Share / Earnings per Share.
2. Step 2: Analyze the purpose of the P/E ratio. The P/E ratio indicates how much investors are willing to pay for each dollar of a company's earnings. A higher P/E ratio suggests that investors expect higher growth or profitability in the future, while a lower P/E ratio may indicate undervaluation or lower growth expectations.
3. Step 3: Review the incorrect interpretations provided in the problem. The P/E ratio does not measure the proportion of assets financed by debt (this is related to the debt-to-assets ratio), nor does it measure the percentage of earnings paid out as dividends (this is related to the dividend payout ratio). It also does not represent net income divided by total assets (this is related to return on assets).
4. Step 4: Identify the correct interpretation. The correct interpretation of the P/E ratio is that it shows how much investors are willing to pay per dollar of a company's earnings. This aligns with the formula and purpose of the P/E ratio.
5. Step 5: Apply this understanding to evaluate companies. Investors use the P/E ratio to compare companies within the same industry or sector, helping them make informed decisions about whether a stock is overvalued, undervalued, or fairly priced.