Using Financial Statement Analysis to Explain the Variation in Firms' Earnings-Price Ratios‪.‬

INTRODUCTION The price-earnings (P/E) ratio and its inverse, the E/P ratio, represent commonly used measures of the value of a company's stock relative to its earnings potential. Typically computed as the latest closing price divided by the most recent annual basic earnings per share (EPS), the P/E ratio allows for the comparison of firms within a given industry. Two companies with relatively similar current earnings figures might possess markedly different P/E ratios. For example, ExxonMobil and Marathon Oil are both large oil and gas companies that enjoyed strong earnings in 2006 (i.e., EPS of $6.68 and $6.93, respectively). Yet, their P/E ratios calculated at the end of 2006 (i.e., 11.60 and 6.40, respectively) reflected different market perceptions of the two firms. Pratt (2001) notes that such discrepancies exist among firms in their P/E ratios because of investors' expectations concerning future earnings. "The greater the optimism that investors are attaching to [a firm's] future income stream," the higher is its P/E ratio (Pratt, 2001, 44).