Question

If the P/E ratio of a company's common stock were 12, and its earnings were $2.50 per common share:A. the market value of the common stock would be $20.83 per share.B. the market value of the common stock would be $25.00 per shareC. an increase in earnings of $0.20 per share, with no change in the multiple, would result in a market price increase of $2.40 per share.D. an increase in earnings of $0.20 per share, with no change in the multiple, would result in a market price increase of $1.67 per share.

Answer 1

C. an increase in earnings of $0.20 per share, with no change in the multiple, would result in a market price increase of $2.40 per share.

Step-by-step explanation:

The P/E ratio (also sometimes called "the multiple") is simply the current price per share divided by the earnings per share. (Price / Earnings = P/E) If you multiply both sides of that equation by Earnings, you get Price = P/E * Earnings.

So if you have P/E = 12 and Earnings = $2.50/share, the price would be 12 * 2.50/share = $30/share. That means a) and b) are both wrong.

It also means that 12 times the change in earnings will tell you the change in price (if the P/E multiple doesn't change). So a 0.20 rise in earnings will raise the stock price by 12 times that amount or $2.40/share. So c) is the correct answer.