# Question

A research analyst is trying to determine whether a firm’s price-earnings (P/E) and price-sales (P/S) ratios can explain the firm’s stock performance over the past year. A

P/E ratio is calculated as a firm’s share price compared to the income or profit earned by the firm per share. Generally, a high P/E ratio suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E ratio. The P/S ratio is calculated by dividing a firm’s share price by the firm’s revenue per share for the trailing 12 months. In short, investors can use the P/S ratio to determine how much they are paying for a dollar of the firm’s sales rather than a dollar of its earnings (P/E ratio).

In general, the lower the P/S ratio, the more attractive the investment. The accompanying table shows the year-to-date (YTD) returns and the P/E and P/S ratios for a portion of the

30 firms included in the Dow Jones Industrial Average. The entire data set, labeled Dow_2010, can be found on the text website.

a. Estimate: Return = β0 + β1P/E + β2P/S + . Are the signs on the coefficients as expected? Explain.

b. Interpret the slope coefficient of the P/S ratio.

c. What is the predicted return for a firm with a P/E ratio of 10 and a P/S ratio of 2?

d. What is the standard error of the estimate?

e. Interpret R2.

f. At the 5% significance level, are the explanatory variables jointly significant?

g. At the 5% significance level, are the explanatory variables individuallysignificant?

P/E ratio is calculated as a firm’s share price compared to the income or profit earned by the firm per share. Generally, a high P/E ratio suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E ratio. The P/S ratio is calculated by dividing a firm’s share price by the firm’s revenue per share for the trailing 12 months. In short, investors can use the P/S ratio to determine how much they are paying for a dollar of the firm’s sales rather than a dollar of its earnings (P/E ratio).

In general, the lower the P/S ratio, the more attractive the investment. The accompanying table shows the year-to-date (YTD) returns and the P/E and P/S ratios for a portion of the

30 firms included in the Dow Jones Industrial Average. The entire data set, labeled Dow_2010, can be found on the text website.

a. Estimate: Return = β0 + β1P/E + β2P/S + . Are the signs on the coefficients as expected? Explain.

b. Interpret the slope coefficient of the P/S ratio.

c. What is the predicted return for a firm with a P/E ratio of 10 and a P/S ratio of 2?

d. What is the standard error of the estimate?

e. Interpret R2.

f. At the 5% significance level, are the explanatory variables jointly significant?

g. At the 5% significance level, are the explanatory variables individuallysignificant?

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