Financial ratios represent a difficult problem of identification. Any given financial ratio can be interpreted as a target for its management, an indicator of success by an equity or credit analyst, or an instrument of policy in order to signal the markets about the quality of company operations for future funding.
a. Discuss the issues involved with the lack of autonomy of a selected financial ratio such as the P/E ratio.
b. What are the issues with a model where the P/E ratio is the dependent variable in any analysis?
c. The state of the economy has a very direct influence on financial ratios and particularly the P/E ratio. How might you evaluate the movements in the P/E ratio over the cycle as an indicator of market expectations or as a financial ratio that simply reflects the stage of the business cycle and tells us very little about the individual company?