Question

Question 2:
The most commonly used method of valuation of shares in Australia is the price earnings (PE) multiple methodology.

Outline three limitations of using this methodology.

Answer 1

The P/E Ratio or the Price-to-Earnings Ratio measures the current price of a share of a company relative to the earnings per share (EPS) of the company.

P/E Ratios are used to determine value of shares of a company.

The limitations of P/E Multiple Valuation Methodology are:

1) Cases when Earnings is Negative

When companies are not profitable then earnings is zero or negative, which poses a problem in calculation of P/E Ratio. In such cases P/E Ratio method does not help in valuation of a company.

2) Choosing the Appropriate Company as Comparable

In P/E Ratio valuation method, the P/E Ratio of the target company is compared with the P/E Ratio of an appropriate comparable company. It is very important to choose an appropriate comparable company which has the following characteristics:

(i) Belongs to the same sector as the target company

(ii) Has business size similar to the target company

(iii) The assumed future growth rate of the comparable company must be similar to that of the target company

(iv) Use similar accounting methods and adhere to similar accounting standards

3) Less effective in case of Cyclical Firms

Using P/E ratios for cyclical firms can be problematic because cyclical firms are very sensitive to economic conditions, as a result their P/E ratio can be very volatile at any given point of time. This poses problems in finding the valuation of the target company.

Hope this will help..