For the P/E ratio to be a good predictor of stock price,

Question

Quizplus · Accepted Answer

The P/E ratio is calculated by dividing the current market price per share by the earnings per share (EPS) over the past 12 months. Therefore, the earnings used in the denominator should be representative of the firm's future earnings potential. Rolling averages of earnings over multiple years may not accurately reflect a company's current or future earnings trajectory, so option A is incorrect. The P/E ratio is calculated on a per-share basis, so option B is incorrect. While cash flow is important in evaluating a company's financial health, it is not directly related to the P/E ratio, so option D is also incorrect. Option C is the best choice because the P/E ratio is meant to predict stock price based on a company's future earnings potential, and thus, the firm's one-year annual earnings must be representative of its future annual earnings. The P/E ratio is based on the firm's annual earnings per share (EPS) divided by the stock price. To be a good predictor of stock price, the earnings used in the denominator should be representative of the firm's future earnings potential. Therefore, choice C is correct, as it implies that the firm's one-year annual earnings are indicative of its future earnings potential. Choices A, B, and D are incorrect, as they do not address the fundamental issue of ensuring that the P/E ratio is a good predictor of stock price.

For the P/E Ratio to Be a Good Predictor of Stock