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Changing P/Es

Stocks of companies whose earnings grow quickly tend to have higher P/E ratios than stocks of companies whose earnings grow more slowly.

Suppose ABC's earnings had been growing at an annual rate of 13% over the past five years, it was selling at a price of $22.50 a share and had a P/E ratio of 18. If the company's earnings are expected to jump from $1.25 this year to $1.50 next year, that would be a 20% growth rate [$0.25 $1.25 = 20%]. Suppose also that ABC has developed a hot new product and it appears that the new, stronger rate of earnings will persist for several years?

In that case, investors will probably be willing to pay more for the stock and be willing to accept a higher P/E ratio than that of the general market. For example, if the price went up to $30 a share based on earnings of $1.50 a share, the P/E would be 20 [$30 $1.50 = 20].

Price/earnings ratios and stock prices can also go down. If earnings are expected to fall, e.g., to $0.96 a share, investors looking at the reasons for the weakness may conclude that the company's business prospects have dimmed. If that happens, the price may slide, perhaps to $11.50, which produces a P/E of 12 [$11.50 $0.96 = 12].

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