Question

In: Accounting

What are the major limitations of equity valuation using multiples such as P/E or P/B?

What are the major limitations of equity valuation using multiples such as P/E or P/B?

Solutions

Expert Solution

The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS). The price-to-earnings ratio is also sometimes known as the price multiple or the earnings multiple.

P/E ratios are used by investors and analysts to determine the relative value of a company's shares in an apples-to-apples comparison. It can also be used to compare a company against its own historical record or to compare aggregate markets against one another or over time.

  • The price-earnings ratio (P/E ratio) relates a company's share price to its earnings per share.
  • A high P/E ratio could mean that a company's stock is over-valued, or else that investors are expecting high growth rates in the future.
  • Companies that have no earnings or that are losing money do not have a P/E ratio since there is nothing to put in the denominator.
  • Two kinds of P/E ratios - forward and trailing P/E - are used in practice.

The price-to-earnings ratio or P/E is one of the most widely-used stock analysis tools used by investors and analysts for determining stock valuation. In addition to showing whether a company's stock price is overvalued or undervalued, the P/E can reveal how a stock's valuation compares to its industry group or a benchmark like the S&P 500 Index.

In essence, the price-to-earnings ratio indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of that company’s earnings. This is why the P/E is sometimes referred to as the price multiple because it shows how much investors are willing to pay per dollar of earnings. If a company was currently trading at a P/E multiple of 20x, the interpretation is that an investor is willing to pay $20 for $1 of current earnings.

The P/E ratio helps investors determine the market value of a stock as compared to the company's earnings. In short, the P/E ratio shows what the market is willing to pay today for a stock based on its past or future earnings. A high P/E could mean that a stock's price is high relative to earnings and possibly overvalued. Conversely, a low P/E might indicate that the current stock price is low relative to earnings.


Related Solutions

There are two major approaches to corporate valuation: a) using comparable firms (via multiples, i.e. ratios)...
There are two major approaches to corporate valuation: a) using comparable firms (via multiples, i.e. ratios) and b) discounted cash flows based methods (FCF models, capital budgeting metrics all fall into this category). Based on the case, which method (A or B above) do you find more useful? Briefly discuss relative strengths and weaknesses you can think of for both methods. Answer detailed.
How can price multiples such as P/E, P/S, or P/B used to forecast future stock prices?...
How can price multiples such as P/E, P/S, or P/B used to forecast future stock prices? Keep in mind no ratio is evaluated in isolation.
What are the limitations of stock valuation?
What are the limitations of stock valuation?
what are the main problems of applying valuation multiples in practice?
what are the main problems of applying valuation multiples in practice?
What are the primary differences among the CF valuation model, asset-based valuation model, and multiples valuation...
What are the primary differences among the CF valuation model, asset-based valuation model, and multiples valuation model?
What are the primary differences among the CF valuation model, asset-based valuation model, and multiples valuation...
What are the primary differences among the CF valuation model, asset-based valuation model, and multiples valuation model?
What are the implicit assumptions made when valuing a firm using multiples? Explain why several valuation...
What are the implicit assumptions made when valuing a firm using multiples? Explain why several valuation models are required to value a stock Discuss why investors who identify positive-NPV trades should be skeptical about their findings, unless they have inside information or a competitive advantage. As part of that, describe the return the average investor should expect to get. What is the efficient market hypothesis? What are its implications for corporate managers?
What is a P/E ratio, and why is it important in stock valuation? Choose a company...
What is a P/E ratio, and why is it important in stock valuation? Choose a company stock, and discuss its P/E ratio. Do you believe the P/E ratio provides an accurate assessment of the company’s performance?
What is your estimated valuation of Deutsche Bank? (Use the P/E and P/TB ratios to value...
What is your estimated valuation of Deutsche Bank? (Use the P/E and P/TB ratios to value Deutsche Bank’s equity share.)
Discuss the merits and limitations of using the method of comparables as a valuation method.
Discuss the merits and limitations of using the method of comparables as a valuation method.
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT