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Market Efficiency

Four companies are in fast expanding sectors. Each has a steady price to earnings ratio (P/E). Each company is about to publicize new products that could boost their earning per share (EPS). In one case a company will make known that the FDA has rejected a proposed new drug. In each case, analysts will be able to immediately project the change in the companys EPS (abbr. Inc. in EPS). Presume the P/E remains constant. Data for these companys includes the increase in EPS is shown below.

Firm Price P/E Cur EPS Inc. in EPS
Tata $72.00 $12.00 $6.00 $0.50
Bare $104.40 $8.70 $12.00 $0.87
Kita $112.00 $14.00 $8.00 $2.00
Plond $52.50 $15.00 $3.50 -$1.00

What should happen to the price in an efficient market? How soon? Are investors that pay the price after adjustment paying a fair price and are they expected to earn a normal return? Please display calculations in Excel.

Solution Preview

See the attached Excel spreadsheet. After earnings per share are adjusted, the new price for each stock is found by multiplying its P/E ratio by the new EPS. The stock's prices changed by 8.3 percent, 7.25 percent, 25 percent, and -28.6 percent, respectively.

Notice that the stocks with the highest P/E ratios, Kita and Plond, have also ...

Solution Summary

Risk and return as they relate to market efficiency