Question

You are considering investing in one of two companies. Company A has earning per share of $5 and a market price of $40. Company B has earnings per share of $12 and a market price of $120. Based on that information alone, which company should you invest in? Explain your answer, including what ratio you used to inform your investment decision. Do you think that you have reviewed sufficient information to make your decision? What other information or ratios would be helpful in deciding which company to invest in?

Answer 1

The ratio used here can be P/E ratio.

P/E ratio is Price divided by Earnings

The P/E of Company A is 40/5 = 8 & P/E of Company B is 120/12 = 10

This means that for every 1 increase in EPS of Company A, price will increase by 8 & for company B it will increase by 12.

Now, note that if investor has 120, he can buy 3 shares of company A but 1 share of company B. Hence, if EPS increase by 1, investor will earn 8x3 shares = 24 for company A but only 12x1 shares = 12 for company B

The same applies for downside risk as well. Hence depending upon risk appetite, investor can buy the share.