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In the following scenario, which company did the stock market favor?  The...

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stavia03 | Student, Undergraduate | (Level 1) Honors

Posted August 31, 2012 at 3:05 AM via web

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In the following scenario, which company did the stock market favor?  

The price-earnings ratio of General Motors (automobile) was 8, and the price-earnings ratio of Microsoft (computer software) was 38.  Which company did the stock market favor?  Explain.

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

Posted August 31, 2012 at 3:14 AM (Answer #1)

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Given no information other than what is in the question, we would have to say that investors in the stock market have favored Microsoft.  The reason for this is that their price-earnings ratio is much higher than that of General Motors.

The price-earnings ratio is the ratio of the stock's price per share to the amount that the firm earned per share of stock.  In this scenario, if Microsoft's stock price were $38 per share, the firm would have earnings of $1 per share, thus creating a price-earnings ratio of 38.

This ratio is typically seen as a good indicator of what a stock will do in the future, or at least what investors think it will do.  If the ratio is high, we can tell that investors think that the stock will do well in the future.  Thus, investors think Microsoft is likely to do better than GM.

We should note, however, that it can be somewhat dangerous to compare ratios for companies in such different sectors as software and autos.  It is usually better to compare the ratios of firms that are more similar than these.

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