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Market Efficiency

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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.

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Solution Summary

Risk and return as they relate to market efficiency

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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 ...

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