Question #50887
Assume that you are an investment analyst. Describe and evaluate the rules of thumb employed by you to establish benchmark price- earnings multiples.
Expert's answer
Answer on Question #50887, Management, OtherP/E is the most popular valuation ratio used by investors. It is equal to astock's market price divided by the earnings per share for the most recent four
quarters. The nice thing about P/E is that accounting earnings are a much
better proxy for cash flow than sales. Moreover, earnings per share results and
estimates about the future are easily available from just about any financial
data source imaginable.
The most useful way to use a P/E ratio is to compare it with a certain
benchmark. Good benchmarks are the P/E of another company in the same industry,
the P/E of the entire market, or the same company's P/E at a different point in
time. Each of these approaches has some value, as long as you know the
limitations.
For example, a company that is trading at a lower P/E than its industry peers
could be a good value, but even firms in the same industry can have very
different capital structures, risk levels, and growth rates, all of which
affect the P/E ratio. All else equal, a firm that has better growth prospects,
lower risk, and lower capital reinvestment needs should be rewarded with a
higher P/E ratio.
quarters. The nice thing about P/E is that accounting earnings are a much
better proxy for cash flow than sales. Moreover, earnings per share results and
estimates about the future are easily available from just about any financial
data source imaginable.
The most useful way to use a P/E ratio is to compare it with a certain
benchmark. Good benchmarks are the P/E of another company in the same industry,
the P/E of the entire market, or the same company's P/E at a different point in
time. Each of these approaches has some value, as long as you know the
limitations.
For example, a company that is trading at a lower P/E than its industry peers
could be a good value, but even firms in the same industry can have very
different capital structures, risk levels, and growth rates, all of which
affect the P/E ratio. All else equal, a firm that has better growth prospects,
lower risk, and lower capital reinvestment needs should be rewarded with a
higher P/E ratio.
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