Chartered Financial Analyst (CFA) Level 1 Practice Exam

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Which of the following ratios reflects a company's valuation in relation to its earnings?

  1. Price to Earnings (P/E) ratio

  2. Price to Book Value (P/BV) ratio

  3. Debt to Equity ratio

  4. Return on Equity (ROE)

The correct answer is: Price to Earnings (P/E) ratio

The Price to Earnings (P/E) ratio is a key metric used to assess a company's valuation in relation to its earnings. Specifically, this ratio compares the market price of a company's stock to its earnings per share (EPS). It indicates how much investors are willing to pay for each dollar of earnings generated by the company, providing a clear insight into how the market values the company's current and future profitability. A high P/E ratio may suggest that investors expect future growth in earnings, indicating a higher valuation relative to earnings. Conversely, a low P/E ratio might indicate that the stock is undervalued or that the market expects stagnant growth. This ratio is commonly used by investors to identify overvalued or undervalued stocks based on their earnings performance, making it a critical tool in investment analysis. Other ratios mentioned, such as the Price to Book Value (P/BV) ratio, focus on different aspects of a company’s valuation—mainly its net asset value rather than its earnings. The Debt to Equity ratio measures a company’s financial leverage and risk but does not provide insight into earnings valuation. Meanwhile, Return on Equity (ROE) evaluates a company's profitability relative to shareholders' equity, not directly tying to the stock price or market valuation.