Chartered Financial Analyst (CFA) Level 1 Practice Exam

What does an increase in the P/E ratio generally indicate about a company?

1. Investors expect higher future growth

2. The company has more assets than liabilities

3. The company is experiencing higher operating costs

4. There is a decrease in the net income

The correct answer is: Investors expect higher future growth

An increase in the price-to-earnings (P/E) ratio typically indicates that investors are expecting higher future growth from the company. The P/E ratio is calculated by dividing the current share price by the earnings per share (EPS). When the ratio rises, it suggests that investors are willing to pay more for each unit of earnings, reflecting confidence in the company's potential for increased profitability in the future. This perception of growth can be driven by various factors such as anticipated new products, market expansion, or overall improvements in the company's competitive position. Investors often see a high P/E ratio as a sign that the market has high expectations for the company's earning power going forward, which is a primary reason for the increased valuation in relation to its current earnings. In contrast, the other options do not directly relate to the implications of the P/E ratio. The statements regarding the company’s assets relative to liabilities, operating costs, or net income changes do not specifically stem from changes in the P/E ratio itself but rather represent different aspects of financial analysis. Thus, the increase in the P/E ratio is most meaningfully aligned with expectations of future growth.