Understanding finance

To P/E OR NOT TO P/E?

John Royden, Head of Research

There are many models to choose from when valuing a company and your choice depends on the company as well as what your aims are. Multiplier models offer a quick comparison between companies whereas absolute valuation models involve deeper fundamental analysis of the individual company.

The most commonly used multiplier model is the price- to-earnings (P/E) multiple. Very simply, a company with a high P/E may be considered overvalued when measured relative to peers. There are many multiplier model variations including the price-to-sales (P/S) and the enterprise value-to-EBITDA (EV/EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization)) multiples, which can be used for companies with negative earnings. Although quick to compute, these give little insight into company fundamentals.

Absolute valuation methods calculate the present value of all future cash flows to shareholders to give a current value estimate for the company. They are more complicated to calculate and require subjective inputs, for example dividend growth and interest rates. The final estimates are very sensitive to these inputs. For this reason models including the Dividend Discount Model (DDM) and Discounted Cash Flow (DCF) tend to be used for mature companies in well-developed industries which are past the growth stage.

There is no ‘one size fits all’ when it comes to valuation models. Multiplier models have the benefit of being quick, easy and less subjective but provide you with limited information as a result. If you take the time to get to know a company inside out, absolute valuation models can provide you with more detailed analysis but based on your subjective inputs. If you have created a DCF model, it is important to supplement this with multiplier-based models. Therefore, to answer the question, yes you should use P/E, but it is really part of an ensemble cast.

 

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