Question

An analyst tells you that he uses price/earnings multiples, rather than discounted cash flow valuation, to value stocks, because he does not like making assumptions about fundamentals - growth, risk, and payout ratios. Is his reasoning correct?

Answer 1

Price-to-earnings (P/E) multiple by an estimate of a company’s earnings per share (EPS) provides a quick estimate of the value of the company’s stock that can be compared with the stock’s market price. To conclude whether the stock is relatively fairly valued, relatively undervalued, or relatively overvalued.

His reasoning is incorrect regarding no assumption because in Price to earnings multiple:

1. There is assumption that the comparison asset or assets themselves are efficiently priced, otherwise the stock may not be properly valued

2. The application of accounting standards requires estimates in reporting. In making such choices and estimates, managers may distort EPS as an accurate reflection of economic performance. Such distortions may affect the comparability of P/Es among companies