What are the pitfalls of using a price/earnings valuation approach? When is it most appropriate?

Expert Solution

Price to earning multiple can be dangerous at times as it can assign higher valuation to the company as if the company is projecting a high growth rate and it is not able to to convert it and attend the high growth rate then it would be highly misleading in nature.

Profit to earning ratio is always calculated on the Earning per share which is compared with the market price of the share and then price to earning ratio is assigned, so if the market price of the share is not reflective of the true valuation of the company and it is trading on very high multiple or it is trading on very low multiple based upon the sentiment which is not reflective of the price then it can be highly misleading ratio and it can trap people at the top and it can force people to get out of the share at the bottom.

It is most appropriate when it is done with proper valuation which is reflecting the true value of share at par with the current market value.

When the current market value of a share is not reflective of unnecessary euphoria and unnecessary panic and it is reflecting a related intrinsic value of the share, then price to earning approach should be appropriate.

jeff jeffy answered 1 year ago

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