According to Shim and Siegel (1999), "The price-earning ratio equals market price of stock divided by earnings per share. It is used by potential investors in deciding whether to invest in the company. A high P/E ratio is desirable because it indicates that investors highly value a company's earning by applying to it a higher multiple" (p. 343). A company's P/E ratio is dependent on a number of factors, including the quality of the company's earnings, the stability of those earnings, risk trends in earnings, cash flow, liquidity position, solvency status, and growth potential; however, financial analysts who believe that the company will generate future profits at higher levels than currently may value the stock higher than its current earnings justify (Shim and Siegel, 1999).
This speculative factor has frequently proven sufficiently compelling to add as much as 4 percentage points annually to the fundamental return, or to reduce it by an equal amount (Bogle, 1999). According to this author, "Over a 25-year period, for example, an increase in the price -- earnings ratio from 8 to 20 times will add 4 percentage points to return; a drop from 20 times to 7 times will do the reverse. The difference between the fundamental and the actual return on stocks, then, is accounted for by the element of speculation -- the changing valuation that investors place on common stocks, measured by the relationship between the stock prices and corporate earnings per share" (Bogle, 1999 p. 36).
Moreover, both the price-earnings ratio and the level of stock prices can increase if the return on surplus rises sufficiently when warranted growth declines (Kopcke, 1992). Statistical tests of price-earning ratios have identified little correlation between these ratios and the size of the companies as measured by sales, total assets, or net worth; furthermore, they are not generally correlated with sales growth rates (Roberts, 1991). This author suggests that, "The most cogent explanation is that the spread in the P/E ratios shows the effects of industry fads, special circumstances of the companies, and different timing relative to hot markets" (Roberts, 1991 p. 230).
In real-world applications, these factors can have important consequences. For example, the distribution of returns widened in 1998 and 1999, just as the distribution of stocks' prices relative to earnings did; this increasing dispersion of valuations, in isolation, did not indicate a gloomier prospect for most companies' earnings (Kopcke, 2001). While the price of more stocks decreased during 1998 and 1999 than during any of the preceding seven years, the prices for these stocks fell from levels that had uncommonly high valuations: "The prices of most stocks at the end of 1999 were still high compared to their companies' earnings, indicating that analysts expected earnings for all tiers of the 500 to continue growing rapidly compared to previous experience" (Kopcke, 2001 p. 31). According to Rutherford (1995), there is a modified version of the price-earnings ratio available wherein earnings are measured as post-tax earnings plus non-cash provisions (e.g. depreciation). "This ratio removes some of the effects of conservative accounting, making international comparisons more meaningful," Rutherford advises (emphasis added), but adds that, "As depreciation reflects the capital intensity of an industry, the cash price-earnings ratio will undervalue service industry shares" (p. 63).
Discounted cash flow. According to Hussey (1999) the discounted cash flow (DCF) is, "A method of capital budgeting or capital expenditure appraisal that predicts the stream of cash flows, both inflows and outflows, over the estimated life of a project and discounts them, using a cost of capital or hurdle rate, to present values or discounted values in order to determine whether the project is likely to be financially feasible" (p. 131). A number of appraisal approaches incorporate the DCF principle in their analyses, such as the net present value, the internal rate of return, and the profitability index; in addition, most computer spreadsheet applications include a DCF appraisal routine (Hussey, 1999). On the downside, though, Lippitt and Mastracchio (1993) report that "the discounted cash flow method... is infrequently used, as it superficially appears to be a difficult procedure to perform," a reference to the complexity of the calculations involved; the authors also note the infrequency of the use of the DCF method, but suggests that the problem is not just complexity of calculations, but rather the speculative nature of the projections necessary to employ DCF (Lippitt and Mastracchio, 1993).
Lloyd and Hand (1982) suggest that the appropriate amount to be capitalized under the DCF model is:
1) CF = E + D - CAP + dWC + dLTD, where CF is the annual cash flow measure, is the annual net income, (1) is the annual depreciation charge,
CAP is the gross annual capital expenditures, dWC is the annual change in working capital, and dLTD is the annual change in long-term debt.
The amounts required for calculating CF for any prior period are readily available from a company's financial records; because the discounted cash flow model deals with future cash flows, which are not available, though, they must be forecasted in some fashion (Lippitt and Mastracchio, 1993).
This valuation approach, like price-to-earnings techniques, remain meaningless, though, when a company does not have any earnings but its revenues are growing exponentially. According to Desmet, Francis, Koller and Riedel (2000), this case especially the case with up-and-coming dot.com companies, for example, and some analysts have suggested using benchmarks such as multiples of customers or multiples of revenues three years out to refine the process. These authors emphasize though, "These approaches are fundamentally flawed: speculating about a future that is only three or even five years away just isn't very useful when high growth will continue for an additional ten years. More important, these shorthand methods can't account for the uniqueness of each company" (Desmet et al., 2000 p. 148).
According to Desmet and his colleagues, the most effective way of valuing such companies is to return to economic fundamentals with the DCF approach, which makes the distinction between expensed and capitalized investment, for example, unimportant because accounting treatments do not affect cash flows; moreover, the dearth of relevant historical data and positive earnings to provide a basis for price-to-earnings multiples does not affect such analyses because the DCF approach, by relying solely on forecasts of performance, can easily identify the fundamental worth of value-creating businesses that tend to lose money for their first few years of operation (Desmet et al., 2000). These authors conclude that, "The DCF approach can't eliminate the need to make difficult forecasts, but it does address the problems of ultrahigh growth rates and uncertainty in a coherent way" (Desmet et al., 2000 p. 148).
Current literature stresses the importance of the discounted cash flow model, but many critics suggest that the approach remains too complicated and speculative in nature to represent a viable approach to company valuation for many practicing managers (Lippitt & Mastracchio, 1993). Indeed, while each of the foregoing evaluation techniques offers some advantages depending on the setting and circumstances, a growing number of analysts and practicing managers recognize that the net present value rule and other discounted cash flow approaches remain inadequate because they are unable to properly capture management's flexibility to adapt and revise later decisions in response to unexpected market developments. According to Trigeorgis (1995), "Traditional net present value makes implicit assumptions concerning an 'expected scenario' of cash flows and presumes management's passive commitment to a certain 'operating strategy (e.g., to initiate the project immediately and operate it continuously at base scale until the end of a prespecified expected useful life) " (p. 1). Likewise, the price-earnings ratios of companies can diverge when shareholders discount their returns at different rates, as can be the case when companies represent different risks; similarly, companies' price-earnings ratio can change over time when shareholders perceive their risks differently (Kopcke, 2001).
In real world situations, though, where change, uncertainty, and competitive interactions are characteristic, there must be a recognition that cash flows will most likely be different than what management originally expected; however, as new information becomes available and uncertainty about market conditions and future cash flows is gradually resolved, management may have valuable flexibility to alter its operating strategy in order to capitalize on favorable future opportunities (Trigeorgis, 1995). In the final analysis, because every company is unique, savvy financial analysts will approach each valuation case using the method most effective for investment analysis purposes depending on the relevant financial data that is available and what speculative considerations are required to develop the most comprehensive and reliable findings possible.
Black's Law Dictionary. (1990). St. Paul, MN: West Publishing Co.
Bogle, John C. (1999). Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor. New York: Wiley.
Desmet, Driek, Tracy Francis, Alice Hu, Timothy M. Koller and…