Why might investors intentionally choose stocks with high price/earnings (P/E) ratios?

• A. Stocks with high P/E ratios guarantee higher consumer surplus for investors.
• B. High P/E ratios always indicate undervalued stocks with low risk.
• C. They expect the companies to have strong future growth, increasing their willingness to pay above current earnings.
• D. Investors prefer high P/E ratios because these stocks pay higher dividends.

Answer: (C)

Verified step by step guidance

1. Understand what the Price-to-Earnings (P/E) ratio represents: it is calculated as \(\text{P/E} = \frac{\text{Price per Share}}{\text{Earnings per Share}}\). This ratio shows how much investors are willing to pay for each dollar of current earnings.
2. Recognize that a high P/E ratio means investors are paying more for each unit of current earnings, which often reflects expectations about the company's future performance rather than its current profitability.
3. Consider why investors might be willing to pay a premium: they expect the company to experience strong future growth in earnings, which would justify a higher price now because future profits are anticipated to be larger.
4. Note that a high P/E ratio does not guarantee higher dividends or lower risk; instead, it signals optimism about future growth potential, which can come with higher risk.
5. Conclude that investors choose stocks with high P/E ratios primarily because they believe the company will grow significantly, increasing the value of their investment over time.