Question

An investor estimates that next year’s net income for Hillary Pullman Hotel would be RM 8 million. The company has 0.5 million shares outstanding and decided to pay RM 0.5 million to the preferred stockholders from its net income. Listed companies similar to Hilary Pullman Hotel have been recently reported to have an average price/earnings ratio of 4 times. Given the information, calculate the expected price of the stock and evaluate the problems using the Price/earnings ratio method of valuing the shares of a company.

Answer 1

Net income per share=net income/shares outstanding=8/0.5=16

Earnings per share(EPS)=net income per share-preferred stock dividend per share=16-0.5=15.5

Price of Share=p/e*EPS=4*15.5=$62

iThe problems with P/E method are:

it simplifies complex information into just a single value. This effectively disregards other factors that affect a company’s intrinsic value such as growth or decline.

2. It can also lead to difficulty in comparing companies or assets. This is because companies, even when they seem to have identical business operations, may have different accounting policies. Hence, multiples may be easily misinterpreted and comparisons are not as conclusive.

3. It also disregards the future point in time – it is static. It only considers the company’s position for a certain time period and fails to include the company’s growth in its business operations.