Question

Answer the following questions regarding the equity valuation methods.

a.

What value can the Price/Earnings ratio provides to financial managers that the Dividend Discount Models(DDM) can not?(15%)

b.What value can the Price/Sales ratio provides to financial managers that the Price/Earnings ratio can not?(10%)

Answer 1

a]

The value that P/E ratio provides, which DDM cannot are :

• P/E ratio can be used for stocks which do not pay dividends
• For the DDM to be applied, the growth rate must be lower than the cost of equity. If this is not the case, the DDM cannot be applied. However, P/E ratio has no such restriction
• P/E ratio method does not require estimating the cost of equity, or the projected dividends

b]

The value that P/S ratio provides, which P/E cannot are :

• P/S ratio can be applied in cases where a firm has negative earnings. P/E ratio cannot be applied in such cases
• The value of earnings used in the P/E ratio is subject to several adjustments such as non-recurring items, diluted shares, diluted earnings, non-recurring items etc. However, the value of sales can be usually taken directly, and hardly requires any adjustments.