Question

Describe how an investor would use the PE ratio model to calculate the value of a share of stock. Please be specific. Discuss the problems involved in using the PE model to value stocks

Answer 1

PE ratio refers to a ratio which states that how much times the company is valued as per its earnings. In other words, it can also be said that within how much times, the earnings from the company will help the investor in recovering the investment.

Formula for PE ratio is as follows:

PE ratio= Market Price Per Share/Earnings Per Share

Now following this above formula, an investor can compute the fair price of stock as per the earnings per share reported by the company.

Such expression will be as follows:

PE ratio*Earnings Per Share = Market Price Per Share

Thus using the above relation, the investor would be able to compute the fair price of stock as per its earnings reported by the company. However, the actual price in the market could differ from the fair price of the stock as computed by the above method.

Following are the problems associated with the PE model as follows:

1) The greatest and, by a wide margin, the most perilous segment of the P/E ratio is that the profit are the accounting income as characterized by the bookkeeping norms for a specific nation. These income are not the actual profit of the business. Numerous organizations recorded on the stock trade win no money in spite of revealing benefits.

2) An issue with the P/E ratio that will be that future income will be at any rate what they are as of now. On account of an organization exchanging on a 10 times P/E ratio, financial specialists are taking a risk that profit will be in any event what they are today for the following 10 years. Filling in as a speculator in the business, it is very certain that assessing the profit of an organization recorded on the stock trade for a year or two into what's to come is amazingly troublesome, not to mention 10 years into what's to come.

3) Another issue with the P/E ratio is the possibility that multiple times profit is less expensive than multiple times income. The ratio that an organization will win its present income for the following 10 years and a financial specialist will recover their cash is, obviously, hypothetical. An organization's income may well go up essentially or down altogether throughout the following 10 years.  

4) The P/E proportion educates the speculator nothing concerning an organization's monetary record. It might be that an organization exchanging on a 2 times P/E different is entirely costly since the organization has a lot of current obligation that it has no chance to get of paying, and as a result, the organization will be proclaimed bankrupt in the current money related year.

5) The P/E proportion reveals to us nothing about the nature of an organization's profit. We may see one organization exchanging on multiple times income and proclaim it less expensive than an organization exchanging on multiple times profit.

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