How is the price-earnings (PE) ratio computed?

• A. Net income divided by total assets
• B. Earnings per share divided by market price per share
• C. Market price per share divided by book value per share
• D. Market price per share divided by earnings per share

Answer: (D)

Verified step by step guidance

1. Understand the concept of the Price-Earnings (PE) ratio: It is a financial metric used to evaluate the relative value of a company's shares by comparing its market price to its earnings per share (EPS).
2. Identify the formula for the PE ratio: The formula is \( \text{PE Ratio} = \frac{\text{Market Price per Share}}{\text{Earnings per Share (EPS)}} \).
3. Clarify the components of the formula: The 'Market Price per Share' refers to the current trading price of one share of the company's stock, and 'Earnings per Share (EPS)' is calculated as \( \text{Net Income} \div \text{Number of Outstanding Shares} \).
4. Apply the formula: To compute the PE ratio, divide the market price per share by the earnings per share (EPS). Ensure both values are expressed in the same currency and are accurate.
5. Interpret the result: A higher PE ratio may indicate that the market expects higher growth or profitability from the company, while a lower PE ratio might suggest undervaluation or lower growth expectations.