Question

Explain three (3) challenges with examples for both Price Earnings (P:E) ratio and Discounted Cash Flow (DCF) for valuing companies that are not quoted in the stock market.

Answer 1

3 Challenges for P/E for unlisted companies i.e. companies which are not listed on the stock exchange.

1) Earnings used in the formula P/E are not cash earnings - The most challenging factor of P/E ratio is that the earnings are the accounting earnings as defined by the accounting standards for a particular country. These earnings are not the cash earnings of the business. In fact, many companies earn no cash despite reporting profits.

2) The P/E ratio tells the investor nothing about a company's balance sheet. It can be possible that a company trading on a 3 times P/E multiple is actually incredibly expensive since the company might be having huge amounts of debt on its balance sheets and no funds to pay it, and as a consequence, the company will be declared bankrupt in the current financial year. We need only look back to the recent global financial crisis to find many examples of companies in exactly that situation.

3) The P/E ratio tells us nothing about the quality of a company's earnings. We may look at one company trading on 10 times earnings and declare it cheaper than a company trading on 20 times earnings.

3 Challenges for DCF for unlisted companies i.e. companies which are not listed on the stock exchange.

a) Operating Cash Flow Projections - DCF involves predicting future cash flows for 5-10 years and then discounting them back to the current value. Well, predicting future cash flows is easier said than done. Any analyst who is performing a discounted cash flow might be able to predict the free cash for the current year, next year but it would be extremely difficult to predict the cash flow for the 5th year with utmost accuracy.

b) Capital Expenditure Projections i.e. Capex - Well again, while computing free cash flows to the firm, we need to account for capital expenditure. Prediciting Capital expenditure might be easy for the next 2 years but it will be a tedious exercie to predict them for the 5-10 years span. In addition to this, any error in computing the capex expenditures for the initial yers can lead to huge variations in the data set in the following years.

c) Discount Rate and Growth rate - Both of them are the centre of attraction in any DCF Model. For computing the present value of future cash flows we need to discount them using a discount rate i.e. Weighted avg cost of capital (WACC) or cost of equity in case of FCFE. Now the problem comes in the very much fact, that for cost of equity, there are two broadly established approaches one being CAPM and one Gordon Growth Model. They require Beta and market price respectively, which are not available for a private firm.