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Future growth potential is one of the
biggest determinants of a stock's price. A firm that expects to have high future
growth in earnings will have a high stock price in relation to its current
earnings. Investors will pay a premium for a high-growth stock today in
expectation of larger dividends or capital gains in the future. This firm will
consequently have a high P/E ratio.
A firm's debt-to-equity ratio is another factor
that influences the stock price and therefore the P/E ratio. A firm with a small
amount of debt will be valued higher in the market than if it had a large amount
of debt. In this case, its stock's P/E ratio would be higher due to its higher
price.
The quality of a firm's management can also
influence the price of a stock. Investors who think a company has high-quality
managers will be willing to pay a premium for its stock because they believe
these managers will deliver earnings growth in the future. Their faith in
management results in a stock price valuation greater than its earnings and
growth rate would otherwise indicate.
The quality of earnings is largely a measure of a
firm's accounting methods. Income statements can be manipulated to a certain
extent in order to report either higher or lower net earnings. If a firm uses
sound, conservative accounting practices, the quality of earnings is deemed
high. Firms with a high quality of earnings generally have higher P/E ratios.
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