Question

Q#3(Chapter 7). You learned that stocks could also be valued using the P/E ratio multiple method. (a) What are the main drawbacks of P/E multiple approach compared to constant dividend/cash flow models in valuing stocks? (b)  If a firm's future earnings growth rate falls and its required return on equity (r_s) rises due to Coronovirus effects, then what will happen to the firm's P/E ratio?

Answer 1

P/E ratio isthe ratio of stock price to earnings per share(EPS). This method comes under multiplier models of share valuation.

(a) Drawbacks of P/E approach are as follows:

• They do not consider future.This is true if values are calculated from the current value of EPS. However this can be countered by forecasting EPS.
• This method is a relative method. It does not gives absolute results. This means that analysts need to analyse the result by comparing it to other industry standards or other results of similar firm in an industry.

(b)P/E ratio is related to the gordon growth model. The expressions developed are interpreted as justified value of the multiple. We know according to Gordn growth model ,

value of share P0= D1/(r-g)

Dividing both sides by EPS

P0/ EPS = (D1/EPS)/(r-g)

= p/(r-g)

where D1 = dividends

This phenomenon is called dividend diplacement of earnings.

P/E ratio is inversely related to required rate of return(r) and directly related to the growth(g). This means that P/E becomes smaller with increased rate of return and it increases when growth is increased.

When growth is decreased and rate of return increases , the P/E ratio decreases. This is because the value in the denominator increases.