Question

Identify and elaborate the main difficulties associated with Price Earnings (P:E) Ratio and Discounted Cash Flow (DCF) for valuing companies which are not quoted in the Stock Market?

Answer 1

Difficulties for the companies which are not associated in the stock market

In P/E:

• Non-availability of a peer company or industry in the stock market. As the P-E ratio is a relative valuation technique so peers are mandatory to carry out the valuation. But if we don't find sufficient peers who are working in the same or relative industry listed in the stock market then we can't proceed.
• Negative earnings of the unlisted company. If there are negative earnings and cash flows of the unlisted company then we will get a negative price which is inaccurate and limitation of the process of valuation.
• The different capital structure of the unlisted company. If the capital structure of the company i.e. Debt-Equity ratio is very different from its peers then we cannot apply relative valuation in that company until unless we find a similar peer.

In DCF:

• Future growth prediction will be difficult if the company doesn't have any particular pattern in historical growth. If the company's historical growth rate is absurd or doesn't have any pattern then future growth rate assumptions will mislead the valuation.
• Finding a discounting rate or WACC calculation will be a challenge as extra risks are involved with the company. The discounting factor is the reflection of the risk involved in a company. So the discounting factor cannot be simply the WACC value. It has to be adjusted with the extra risk associated with the business. It will be a challenge.