Business Finance Essay

Part 1.

Calculation of PE Ratio

The formula of PE ratio is shown as follows:

PE Ratio=(Stock price)/EPS

Based on the formula, PE ratio of each company can be calculated out. The industry simple average price-earnings (PE) ratio can be then concluded. The results are shown in the following table.

EPS Stock Price PE ratio

Artic Cooling $0.82 $15.19 18.52

National Heating & Cooling 1.32 12.49 9.46

HVAC Corp 2.34 48.6 20.77

Benchmark PE 16.25

EPS and stock price for Ragan Thermal Systems can be calculated as shown below:

EPS=Earnings/shares=$320,000/(50,000¡Á2)=$3.2

Stock Price=EPS¡ÁPE Ratio=$3.2¡Á16.25=$52

Part 2.

Comment on the PE ratio statement

PE ratio approach is relatively easier than valuation approaches by using discounted cash flow, but PE ratio can be affected by three factors basically. Thus, caution is warranted when using PE ratio to value stocks.

Firstly, PE ratio is related to the growth opportunities of a company. Companies with higher growth opportunities normally sell at higher prices, hence the PE ratios for firms with higher growth opportunities should be higher than those with limited growth opportunities. Since Ragan has experienced rapid growth in the recent few years, the PE ratio of Ragan should be higher than the average level of this industry.

Moreover, riskiness should also be considered when adopting PE ratio approach. It is expected that low-risk stocks are likely to have high PE ratios, since there is a positive correlation between discount rate and stock¡¯s risk and variability. Thus, more valuation of Ragan¡¯s riskiness should be done when using PE ratio.

Lastly, the accounting approach may also influence the PE ratio. Companies using conservative accounting practices, like the accounting treatments to inventory, depreciation and construction costs, are more likely to have higher PE ratios. Therefore, the accounting practices of Ragan and its competitors still need more examinations.

Another way of valuing the stock price ¨C Dividend Discount Model

In this model, the stock price can be valued using the following formula (assume the dividend is at Year 0):

Stock Price=(Div¡Á(1+g))/(R-g)

The parameter