The market price of Friden Company's common stock increased from $15 to $18. Earnings per share of common stock remained unchanged. The company's price earnings ratio would:

a. Increase

b. Decrease

c. Remain unchanged

d. Impossible to determine

a. Increase

Explanation:

The price earnings ratio is calculated by dividing the market value per share by the earning per share. This means that the price of the share is in the numerator and the earnings per share is in the denominator. If the denominator increases the ratio will decrease and if the numerator increases the ratio will increase. In this case the price of the stock which is the numerator increases from 15 to 18 whereas the earnings which is the denominator remains the same, this means that the price earnings ratio will increase. We can see this example numerically

We know the price of the stock was $15, lets assume the earnings were $1. So before the price change the earnings per share ratio would be 15/1 = 15.

When price increases to $18 and earnings remain the same the new price earnings ratio will be 18/1=18. This proves that when earnings are constant and price per share increases the price earning ratio increases.