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Multiplier Approach To Share Valuation

The document discusses various approaches to valuing company shares, including the P/E ratio and limitations thereof. Specifically, it notes that while a high P/E ratio is often considered favorable, it may be misleading if due to low earnings rather than high share price. The PEG ratio is then introduced as a method that adjusts the P/E ratio to account for a company's earnings growth rate. Finally, the PERG ratio is mentioned as an alternative approach that incorporates risk into the valuation by using metrics like the beta coefficient and return standard deviation.

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734 views2 pages

Multiplier Approach To Share Valuation

The document discusses various approaches to valuing company shares, including the P/E ratio and limitations thereof. Specifically, it notes that while a high P/E ratio is often considered favorable, it may be misleading if due to low earnings rather than high share price. The PEG ratio is then introduced as a method that adjusts the P/E ratio to account for a company's earnings growth rate. Finally, the PERG ratio is mentioned as an alternative approach that incorporates risk into the valuation by using metrics like the beta coefficient and return standard deviation.

Uploaded by

I am Indian
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Multiplier Approach to Share Valuation

The P/E ratio of a company indicates willingness of investors to pay for a rupee of EPS of
the company. Despite, numerator is not having any vagueness; there may be many options
for the denominator. Generally, the next four quarters expected EPS form the base for
forward P/Es and the last four quarters observed EPS form the base for trailing P/Es.

However, P/E ratio can mislead about the performance of a share. Though, high P/E ratio is
considered better, but a caution must be taken to check, if it is high due to low EPS, instead
of high share price. P/E ratio has limitations and may be changed by accounting policies that
may result in distortion of fair earning’s estimation. So, it becomes difficult to rely on EPS
and P/E ratio as measure of performance due to uncertainty in the interpretation of EPS.
Even if the profit earning potential of a company is high, if its equity-base is large, the EPS
and hence MPS would be low. When a company declares rights or bonus, or if its debentures
are converted, its equity rises, diluting the EPS.

Further, a low-P/E does not mean a buying opportunity, as Infosys like company which has
high P/E above than 25, still preferred by investors against low-P/E companies, due to
expected future growth rate. Infosys in-spite of its high P/E ratio has been preferred to other
company because of its growth rate, liquidity and faith in management. An appropriate P/E
estimated on the basis of the growth rate of earnings, both past and present, past sales
growth, the stability of past earnings, financial strength, nature of industry, and competitive
position of the company.

The P/E ratios suffer from two issues: it does not consider growth or risk factors of the firms.
This has led to analysts using price-earnings to growth (PEG) ratios to adjust for growth. The
PEG ratio indicates potential value of a company that is derived from the P/E ratio and
growth rate of EPS. The trade-off between the price, earnings (EPS) and expected growth
rate of company is determined by the PEG ratio, which is used as a valuation metric.

If we use only the P/E ratio, high-growth companies may seem to be overvalued in relation to
other companies, i.e., the P/E ratio is higher for a company with a higher growth rate. That is
why, if P/E ratio is divided by the earnings growth rate, it gives out a better understanding of
comparable growth rate companies. The P/E ratio of any company that’s fairly priced will
equal its growth rate, i.e., PEG for a fairly valued company will be equal to 1.

However, there are studies which suggest that the use of PE and PEG may ignore ‘risk’,
which is a very important factor otherwise. Those stocks are the best stocks on the basis of
valuation with lowest PERG ration. Stocks with lowest PERG are either cheap, or that are
anticipated to grow fast, or that are not very risky. It means stocks with lowest PERG are
having low-P/E, or high growth, or low risk. To compute PERG ratio the beta coefficients and
the standard deviation of return are used as alternatives for risk.

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