Suggest which stock ratio indicates to an investor that the risk related to a stock is high. Provide support for your rationale.
The price-to-earnings ratio (P/E ratio) is calculated as a stock's current share price divided by its earnings per share (EPS) for a twelve-month period (usually the last 12 months, or trailing twelve months (TTM)). [ Most of the P/E ratios you see for publicly-traded stocks are an expression of the stock's current price compared against its previous twelve months' earnings.
A stock trading at
$40/share with an EPS (ttm) of $2 would have a P/E of 20 ($40/$2), as would a stock priced at $20/share with an EPS of $1 ($20/$1). These two stocks have the same price-to-earnings valuation - in both cases investors pay $20 for each dollar of earnings.
But, what if a stock earning $1 per share was trading at $40/share? Now we'd have a P/E ratio of 40 instead of 20, which means the investor would be paying $40 to claim a mere $1 of earnings. This seems like a bad deal, but there are several factors which could mitigate this apparent overpricing problem.
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