ACCA Financial Management (F9) Certification Practice Exam

What aspect does the P/E ratio method of valuation primarily focus on?

1. Historical data of the company's performance

2. Future earnings potential of a company using dividends

3. Non-monetary aspects of the firm

4. Comparison with industry averages

The correct answer is: Future earnings potential of a company using dividends

The P/E (Price-to-Earnings) ratio method of valuation primarily emphasizes the future earnings potential of a company. This ratio is calculated by taking the market value per share and dividing it by the earnings per share (EPS). Investors use the P/E ratio as a metric to gauge how much they are willing to pay today for a dollar of a company’s future earnings. A higher P/E ratio suggests that investors expect future growth in earnings, while a lower P/E might indicate that the company is undervalued or that investors expect slower growth or declining earnings. Focusing on future earnings potential aligns directly with the fundamental principle of investing, which is to assess whether the current price of a stock reflects its expected growth in income over time. As a result, the P/E ratio provides insight into market expectations regarding a company's earnings and can aid investors in making informed decisions about equity investments. In contrast, other choices may touch on relevant aspects but do not capture the essence of what the P/E ratio intrinsically represents in valuation context. For instance, historical data, non-monetary aspects, or comparisons with industry averages might provide useful information but do not specifically relate to the focus of the P/E ratio on anticipated future earnings.