While PE multiple remains one of the most popular methods of equity valuation, it is also one of the most misunderstood and misapplied multiple.
Simply put, PE ratio of a stock is the ratio of current market price of that stock to the earnings per share (EPS) of the same stock (PE = P / EPS). Accordingly, value of common share of the company (or expected price) can be calculated by multiplying estimated PE ratio with the expected EPS of the company (P = PE x EPS).
- Can we simply take average of PE multiples of comparable companies in the industry (or, industry average PE multiple)? – Well, not all companies, even in the same industry, are at the same point of their growth cycle or have the same operating performance. They differ in their size, geographic presence, capital structure – all of which have bearing on their expected earnings and risk & reward scenarios. Moreover, reported earnings of comparable companies need to be reorganized for recurring and non-recurring earnings as well as for operating and non-operating sources of earnings for an accurate multiple analysis.
- Can we simply take historical average PE multiple of a company? – Well, macro environment, investors sentiments and company’s operating performance keeps on evolving and no two operating timeframes are the same.
These leave us with the step-by-step solution that we first arrive at a base PE multiple using the above two methods and finding answers to critical questions raised. Then the second step is applying a premium or discount that we may apply for a company’s PE multiple compared to the industry average PE of the historical average PE of the same company.
This 10-minutes video is an attempt to demystify PE ratio for you and how effectively and rigorously you can apply the same for equity valuation.
For easy comprehension, we have divided this video into four sections:
- Explain the concept of PE and calculation methodology in the simplest possible way followed by key underlying drivers
- Explain different types of PE, their calculation and application
- Providing a practitioner guide to using PE for equity valuation; also explain limitations and when not to use PE for equity valuation
- Applying learning – where we provide all the underlying factors for you to apply learning from the first three sections and arrive at your own conclusion in the right manner
Hope you find this video useful!
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