Price earnings ratio method is considered more superior than net assets based valuation method.
P/E ratio is earnings based approach to business valuation rather than asset-based approach.
P/E ratio considers both market share price and earnings.
If total earnings are used instead of EPS, then market value of the firm will result instead of market share price.
Price earnings ratio represents confidence of investors in the business. Confidence depends on expectations of future cash flows and business & financial risk faced by the business. Increase in investors’ confidence will result in increase in market share price as investors will be prepared to pay more for given level of earnings.
Price earnings ratio should be used related to organization subject to takeover bid. It will give market share price below which existing shareholders will not be motivated to sell their investment in the company.
Acquirer can use its own company P/E ratio to determine the maximum price per share it can afford to pay to existing shareholders in company subject to takeover. Using P/E ratio of acquirer company is risky option especially if P/E ratio of acquirer is higher than P/E ratio of acquiree. It will overstate the value of acquiree business. It should only be used if acquirer has reliable estimates of future earnings and growth after acquisition.
There can be disagreement between both companies on the use of P/E ratio for the purpose of acquisition. In that case, P/E ratio of industry average will give unbiased valuation of the acquiree company.
Earnings may either be estimated earnings for future or recent earnings of organization subject to acquisition.
P/E ratio method is difficult to apply to private limited companies because share price of private limited companies are not quoted on exchange and therefore P/E ratio is not readily available. In that case, we need P/E ratio of similar publicly listed company. Similar company would be operating in same industry and having similar financial risk (gearing) and business risk (operational gearing).
Private limited companies are considered more risk than public limited companies, as public ltd companies have to comply with corporate governances and stock market listing rules, which reduces the risk of default. Therefore, P/E ratio of similar public ltd company is reduced to 2/3 or 1/2 of its value.
Benefits of P/E Ratio Method
P/E ratio considers intangible assets in business valuation such as goodwill.
Investment decision based on P/E ratio method can be easily be justified to selling shareholders, as shareholders takes investment decisions based on P/E ratios and they are familiar with its rationality.
P/E ratio is earnings based approach to business valuation rather than asset-based approach. It is the earnings (cash flows), which are the motive of investment in shares with little concern for what assets generate those earnings.
P/E ratio considers market share price. Market share price accounts for various financial and non-financial factors, which investors consider in making investment decisions.
Limitations P/E Ratio Method
P/E ratio method assumes that earnings will remain same after acquisition. If business is in maturity stage or at the end of growth stage of life cycle then it has peak level of earnings, which may not remain same in decline stage of business. If recent earnings used were exceptionally higher than usual earnings, then P/E ratio will overvalue the business. However, this can be overcome to some extent using average of earnings of previous years.
Market share price fluctuates on day-to-day basis. If P/E ratio relates to the time when share price is overvalued, then P/E ratio will be temporarily higher and business will be overvalued using P/E ratio.
P/E ratio are accounting profit based measure, which includes non-cash flow items and non-recurring items such as provisions and gain on disposal of fixed assets respectively. Motive of investment is to earn cash flows to maximize wealth. Profit is not good representative of cash flows.
P/E ratio for current particular year may be exceptionally higher or lower. In that case, it will provide extra ordinary higher or lower share price respectively. To overcome, this difficulty average P/E ratio should be used.
