Question

There are various limitations to employing the PE Ratio for company to company comparisons. Describe several of the limitations. A better measure would be to employ the PEG Ratio, how would you calculate? List and explain in a one to two page double spaced

Answer 1

A PE Ratio or Price to Earnings Ratio is an important valuation matrix used in real life and is calculated as dividing Price per share by Earnings per Share. The PE ratio implies how much investors are willing to pay for $1 of a firm's earnings.

Although, PE ratio has many advantages, it has several limitations for company to company comparisons including :-

1.) Cyclicality - Firms that go through boom and bust cycles like automobiles can have high or low earnings respectively. So let's say in the period of inflation, the company's earnings were high and thus implying a low PE ratio reflecting as a cheaper price for the investors to buy but in reality its not the right time as soon the earnings are going to fall when the firm is gonna come out of the cycle.

2.) Accounting Standards - A firm's earnings can be depressed or inflated by a one time accounting charge or a one time gain and thus the PE ratio can be presented with a picture which is not true as the earnings in denominator of the ratio made the change. Gradually, when the firm will get to its sustainable earnings level the PE ratio will change.

3.) Disorted Earnings or Manipulation - A firm may have solve a certain subsidiary in a particular country at a very high price, increasing the firm's earnings and making PE ratio low and thus displaying a picture that the stock price is low but actually it may not be cheap.

4) Growth Rate of Earnings Factor - There are two types of PE ratios- Trailing and Forward PE. Trailing uses earnings of past four quarters while the forward PE uses earnings estimates of next four quarters. Generally the forward PE is greater than the trailing PE because of the earnings growth difference of companies with lower of high valuations making their multiples to look cheaper or expensive.

A better measure would be to calculate the PEG RATIO.

Ratio which is calculated as PE RATIO/ EARNINGS GROWTH RATE OF A FIRM. The PEG Ratio also factors in the growth rate of a firm and tells you a better picture than a PE ratio. It serves as a better valuation matrix as explained in the following example :-

Let's say two firms have multiples as 5x but the first one has an expected earnings growth rate of 5% but the second one has a growth rate of 8%. So the second firm is a better choice to make investment.

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