Q1) What is the industry simple average price-earnings (PE) ratio? Based on the industry’s benchmark PE, what is Ragan’s stock price if the firm’s reported earnings = $320,000?
Answer: As evident from the above calculation, the industry simple average price-earnings (PE) ratio is 16.25. On the basis of this price per earnings ratio we can calculate the market price of Ragan’s stock.
Ragan’s earning per share= 320000/100000= $3.4 per share
PE= Market price /Earnings per share
Market price per share= PE* earnings per share
Market price per share= 3.4*16.25
Market price per share= 52 per share
Q2) Comment on the following statement: “Caution is warranted when using PE ratio to value stocks.” Apart from using PE ratio, suggest another way of valuing the stock price based on the information given? Discuss the assumptions and the limitations of this model.
Answer: Caution is warranted when using PE ratio to value stocks because price per earnings ratio might not be able to measure the PE value of stock comprehensively. The stock price depends on several other market and economy based factors apart from earnings even if the position of the company is quite stable. It is possible that the overall market is down and share prices are generally declining in the world market and the confidence of the investors is down, in this case, the market value of the stock would be lower because of the higher risk involved. On the other hand, if the PE earnings ratio is better than the industry or even other companies in the market economy, the investors may put more value on the stock of the company than PE value suggests. So PE ratio alone is meaningless to for making a decision regarding investment in the company.
However, PE ratio provides a good helping tool to make decision about the investment.
However, it is not easy to tell whether a high PE ratio is better or a low PE ratio should be desired a particular time for the investment. We should actually evaluate the reason of high or low PE ratios.
For example, the reason of strong PE ratio could be because the company has sold part of its brand to some other firm. So on the basis of PE ratio, the market value would per share would be higher. However, the future earnings would not be as high as indicated by the PE ratio because the company had sold part of their brand to other company. Due to the lower future earnings expectations, the price of the share will go down but PE ratio would say otherwise. It is basically a historical ratio and not a forward looking ratio.
Another way of valuing stock is is dividend discount model. The model is very straightforward. According to this model, the value of a stock is equal to the present value of all of the future dividends it pays. The DDM is theoretically sound, and people like it because it’s fairly clear and simple.
The Dividend Discount Model has limitations as well. The most obvious limitation is that it does not work for the companies which do not pay dividends. Considering the company pays a dividend, one needs to know what the dividends would be in the future in order to use this model. However, the dividends might not be steady as during the financial crisis, the company may slash the dividends. Moreover, this model is also quite sensitive to the assumptions regarding growth rate and the discount rate used. Due to these limitations, it may have similar problems as with the PE ratios.
Another possible method is to discount the future earnings of the company to the current level. However, this model also requires assumptions regarding future earnings of the company as well as discount rate to be used. So the limitations are again similar to the dividend discount model.