Question

You are estimating the price/earnings multiple to use to value company A by looking at the average price/earnings multiple of comparable firms. Suppose the following are the price/earnings ratios of firms in the industry:

Firm	Share Price	Total Earnings	Share outstanding
B	130	5,000,000	1,000,000
C	30	6,000,000	2,000,000
D	168	30,000,000	5,000,000
E	100	12,000,000	3,000,000

1. What is the average P/E ratio?

2. Would you use all the comparable firms in calculating the average? Why or why not?

3. What assumptions are you making when you use the industry-average P/E ratio to value company A?

Answer 1

a:

P/E of firm= share price/ earnings per share

P/E of firm B= 130/ (5000000/1000000) =26

P/E of firm C= 30/ (6000000/2000000) =10

P/E of firm D= 168/ (30000000/5000000) =28

P/E of firm E= 100/ (12000000/3000000) =25

Average P/E ratio =(26+10+28+25)/4 =22.25

b:

We should not use all comparable firms, if there is any outliers we should eliminate them as the data can get skewed ( in this cas firm C should be eliminated)

c:

The assumptions are

• Company A is similar in performance and growth to the average firm in the industry
• The market valuation of all the other comparable firms are correct.
• P/E average ratio is a clear representation of the market valuation of a company