The Price earnings ratio PE ratio for a stock is a commonly

The Price earnings ratio (PE ratio) for a stock is a commonly used measure of how over-priced or underpriced a company’s stock is. There are a number of different statistics about a company that are available that might explain why this ratio differs for different companies. One of these statistics is a measure of future growth. To examine the relationship between P Es and the measure of future growth (FG), you run a simple regression and get the equation
                                                   PE=3+.9FG.
The R2 for this model is 18% and the standard error is 5. Another model was run using a measure of dividends (D) to explain the PE. This gives the equation
                                                   PE =1.6 + 13.2D
(a) Give a managerial interpretation for the coefficients 3 and .9
(B) A particular company has a value of 15 on the measure of future growth its P E ratio is 4.5 what would you conclude about this company’s PE? Briefly explain
(c) Since 13.2 is greater than. 9 can you conclude the PE ratio has a stronger relationship to dividends than future growth? If not, what would you need to know to conclude which variable has a stronger relationship to the P E ratio? Briefly explain.

Solution

(a)

Interpretation of intercept(3)

In absence of future growth , or when the future growth is zero, the price earning ratio will be 3 .Or in absence of future growth , the stocks will be overpriced by 3 times.

Interpretation of slope(0.9)

The increase in overpricing will be 0.9 times future growth rate of stocks.

(b)

Expected PE = 3 + 0.9*15 = 16.5

The PE ratio is lesser than the price earning ratio expected by the theoretical regression model. This means that inspite of having a massive future growth perspective, the company\'s stock\'s pricing has failed to increased they way it should have .

(c)

No, To find whether a variable has a stronger relationship with PE ratio , we will have to find the R-squared ratio of both regressions. The one having numerical value closer to 1 will have the stronger relationship.