P/E multiples-based valuation is a widely used method of valuing a company’s equity. It involves using the company’s price-to-earnings (P/E) ratio to estimate the fair value of its shares. The P/E ratio is calculated by dividing the company’s stock price by its earnings per share (EPS) over a specific period.
P/E Multiples based Valuation Assumption
The P/E multiples based valuation relies on the assumption that the price of a company’s stock reflects its earning potential, and that investors are willing to pay a certain multiple of earnings per share for the stock. The earnings per share are calculated by dividing the net income of the company by the number of outstanding shares. The P/E multiple is then calculated by dividing the current stock price by the earnings per share.
The key assumption is that the P/E multiple is a reliable indicator of the future earning potential of the company. This assumption is based on the belief that investors are willing to pay a certain premium for a company that has a strong growth potential and is expected to generate high earnings in the future.
However, this assumption is not always true, as there are a number of factors that can impact the P/E multiple, such as changes in market sentiment, fluctuations in interest rates, changes in industry trends, and macroeconomic events. Additionally, different industries and companies may have different P/E multiples depending on factors such as growth potential, market position, and risk profile, making it difficult to compare companies across different sectors. Therefore, it is important to exercise caution when using P/E multiples as a valuation tool and to consider other factors as well.
The Basic Principle behind P/E multiples-based valuation is that investors are willing to pay a certain multiple of a company’s earnings for its shares, depending on various factors such as the company’s growth prospects, industry, competition, and overall market conditions. The P/E multiple is typically based on a comparison of the company’s P/E ratio to that of other similar companies in the same industry or market.
To use the P/E multiples-based valuation method, an investor would typically follow the following steps:
- Identify a group of comparable companies: The investor would identify a group of companies in the same industry or market as the company being valued, and then collect data on their P/E ratios and other financial metrics.
- Calculate the average P/E multiple: The investor would then calculate the average P/E multiple of the group of comparable companies.
- Apply the average P/E multiple to the company being valued: The investor would then apply the average P/E multiple to the company being valued, using its EPS to calculate an estimated fair value for its shares.
For example, suppose that a company’s EPS over the last 12 months was $2.00 and its stock price was $40.00 per share. This would give the company a P/E ratio of 20. If the average P/E ratio for comparable companies in the same industry was 15, then the investor might use a multiple of 15 to estimate the fair value of the company’s shares. Multiplying the EPS of $2.00 by the P/E multiple of 15 would give a fair value estimate of $30.00 per share.
One advantage of the P/E multiples-based valuation method is that it is relatively simple and easy to use. It also allows investors to compare the valuation of a company to that of other similar companies in the same industry or market.
However, there are also some disadvantages to using this method. For example, the P/E multiple may not accurately reflect the company’s true growth prospects or risk profile. The method also assumes that the company being valued is comparable to the group of comparable companies used in the analysis, which may not always be the case. Finally, the method may not be suitable for companies that have negative or volatile earnings, or that operate in industries with high levels of cyclicality or unpredictability.