Albay, Jeremy James G.

BSA-3A
Assignment 4: Equity markets – stock offerings and investor monitoring, and stock valuation and
risk

1. Explain the use of the price-earnings ratio for valuing a stock. Why might investors
derive different valuations for a stock when using the PE method?

One of the methods used by investors in valuing a company’s stock is called the PE
method or price-earnings ratio. It simply bases the firm’s value from the mean ratio of price to
earnings of all other publicly-traded competitors in the market multiplied to the firm’s expected
earnings instead of current or recent earnings. This method emphasizes future earnings as a
determinant of a company’s stock value. The expected earnings formed must be then compared
to its competitors in the industry using their respective price per share over earnings per share.
On laymans terms, this is a visionary estimate of a company’s value or stock.
PE method is popular among investors as a valuation because of how simple it is to come
up to but on the flipside, quite dangerous because it leads to different interpretations or different
valuations. Investors use different variations like for example, earnings forecasted depends on
where the investor based it from and it is open for exaggeration, making the valuation different
from investor to investor. Like there’s no concrete criteria on what to objectively use as a
measure for PE method, just basic rule of expected earnings times competitor’s PE ratio. Which
is inconsiderate of other underlying factors thus relying on forecasts alone may turn out
inaccurate. Also, investors might disagree on what industry norm represents which so no one can
really say what is the mean PE ratio to be used as basis.

2. Explain how are the interest rate, the required rate of return on a stock, and the valuation
of a stock related?

Investors have the choice whether to invest in bonds or stocks. Stocks pose more risk as
the return for investors on stocks depends on the performance of the company on how it can
generate profit. Because of that, risk premium is needed to factor in, making lower stock price
and higher return.
Interest rate also plays a prominent factor in driving stock market prices. Required rate of
return on a stock depends on the movement of the interest rate. With risk premium considered in
investing with stocks, the rate of return for investors should always be higher than risk-free
interest rate in order to compensate the investors who chose stock over for example treasury
bonds and therefore reducing the price of stock. This whole process makes stocks more
appealing, have competition against bonds and shows how risk-free interest rate, required rate of
return on a stock, and the value of a stock are related to each other.

3. Assume that the expected inflation rate has just been revised upward by the market.
Would the required return by investors who invest in stocks be affected? Explain.

Yes, increase in inflation rate affects required return on stocks because inflation affects
the economic growth which in turn affects stock prices and return on investment such as stocks.
When inflation rate rises, interest rates also increase. Based on what I’ve already said in question
no.2 on how interest rate and required rate of return on a stock is related, upward interest rate
forces rate of return on stock be increased more because risk premium is also a consideration.
Interest rate and rate of return has direct relationship. That’s why when inflation happens, not
only the risk-free interest rates are affected but also the required rate of return on stocks because
they both move directly. Increased inflation, expect for higher return. Deflation, expect for lower
return.