P/E Conundrum

Curated and Reviewed by Lesson Planet

In order to present a potential inconsistency in the price to earnings ratio, Sal creates a scenario based on two entrepreneurs who each purchase a pizzeria with identical assets. The first pays the entire cost outright while the second pays 10% and borrows on the rest. Sal outlines the finances for each company, reaching identical operating profits. Next, he incorporates taxes and interest payments (for the second owner) to reach the net income and determine if the price to earnings ratio holds up. Sal uses the "superficial" market capitalization results to show that the P/E ratio breaks down when comparing different capital structures.

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Concepts

assets, net income

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Additional Tags

p/e, price to earnings ratio, assets, net income, different capital structures, social studies

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Resource Details

Grade

Higher Ed

Subjects

Social Studies & History