Certified Valuation Analyst (CVA) Practice Exam

Which of the following factors concerning the price-to-earnings (P/E) method is FALSE?

1. It is based on after-tax earnings

2. It is pretax

3. It compares earnings to stock price

4. It can be influenced by market sentiment

The correct answer is: It is pretax

The price-to-earnings (P/E) method is indeed fundamentally grounded in after-tax earnings rather than pretax earnings. This is because investors typically assess the profitability of a company on the basis of the earnings that are available to shareholders, which is reflected after accounting for taxes. When the P/E ratio is calculated, it is the earnings per share (EPS)—generally derived from net income after tax—that is used in the numerator. The denominator, which is the stock price, provides a ratio that investors can use to gauge how much they are willing to pay for each dollar of earnings. This makes it intuitive for investors since they seek to understand the return on their investment in terms of actual earnings that will contribute to their wealth after tax obligations are met. Additionally, the P/E method compares these after-tax earnings to the stock price, allowing for variations based on market sentiment. Market perception can indeed significantly influence a company's stock price irrespective of its actual earnings, thus further emphasizing why the focus is on after-tax earnings rather than pretax, reinforcing that pretax earnings would not be an accurate reflection of value to shareholders. Therefore, the assertion regarding the P/E method being based on pretax earnings is false, making it the correct response in