Question

what do you think is the rationale for earnings based valuation? Advantages and concerns?

Answer 1

The rational for earnings based valuation is that the prices of the stock are based on based on the future expected earnings. This is referred to as the P/E Ratio. In this approach, we calculate the P/E ratio of the firm historically and then evaluate the firm. If the price is For example $100 and the expected future earnings is $10, then we say that the stock is correctly valued. If the expected future earnings is $9/share and the price is $100 per share, then we can say that the stock is overvalued. Now, in the third case, if the future expected earnings is $11/share and the price is $100 per share, then we can say that the stock is undervalued.

Advantages: Easy to calculate and understand, fairly straightforward and it is applicable for most companies listed on the stock exchange

Disadvantages: Difficult to foresee the future earnings. If the analyst misses something, then there is a possible chance of not buying a good company and buying a bad company.