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In: Finance

Accounting and Finance Identify and elaborate on the main difficulties associated with Price Earnings (P: E)...

Accounting and Finance

Identify and elaborate on the main difficulties associated with Price Earnings (P: E) Ratio and Discounted Cash Flow (DCF) for valuing companies which are not quoted in the Stock Market?

Solutions

Expert Solution

Price earning ratio does not consider debt part of the company and it only takes into account the equity part and thus does not considers the risk associated with debt of the company. Also, it does not take into account the growth of the company or lack of it while valuing the company. Also, it does not take into account the cash earnings of the company but only accounted earnings of the company while there are many companies which doesn't have any cash earnings but accounted earnings are there. Also, issue is with one of the assumption that future earnings will be at least what they are right now while they can change. Also, it does not tell anything about balance sheet of the company. So, it can be possible that company has good price earning ratio but have large amount of debt and is not capable of paying it back and thus is on the verge of bankruptcy.

Discounted cash flow method of valuing company has one of the major difficulties in forecasting operating cash flows. Cash flow forecasting presents a major difficulty for this method as forecasting cash flows for each year is challeging while this method uses upto ten years of forecast. Another difficulty is capital expenditure projections for each year which is again challenging for each successive year. Another difficulty is deciding growth rate or discount rate which this method assumes to be constant till perpetuity while this could not be the case.


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