Valuations

What's Wrong with the Price:Earning Multiple?

Date:

Many Business Valuers, Business Brokers, Auditors and Accountants value private businesses using the Price:Earnings (P/E) Multiple Method.

The question is, is this a fundamental business valuation method?

Furthermore, is this a valuation method that applies to the enterprise valuation computation or equity computation?

What is the P/E Multiple?

It represents the relationship and correlation between earnings (Net Profit After Tax) and the price of a share, i.e the capitalised value of the company, viz equity.

So for example, if the company’s earnings after tax is R100 000 and the share is trading at a value of R100 per share with 1 000 shares issued, the capitalised value is R1 000 000, the P/E Multiple is 10 to 1 (10.0).

Consequently, if one considers a private company’s performance in a particular sector, to be comparable with a listed company, where unlisted companies P/E ratio is 10, one would value the private company’s shares at the current latest NPAT and capitalise it at the P/E ratio of 10.

For example, NPAT latest year is R150 000 x 10 = R1 500 000 is the value of the shares (equity).

However, using the P/E Multiple to value any company has fundamental flaws.

  1. It is not a fundamental intrinsic valuation method – it simply represents the correlation or relationship between historical earnings (NPAT) and the market price based on the share price.
  2. It does not take into account the level of gearing (debt finance) on the Balance Sheet.
  3. It does not take into account the specific business risk of the business and impact on cost of risk.
  4. It makes no reference to projected earnings and the impact on a discounted valuation.
  5. It does not value the business (enterprise or firm) but goes straight into an equity valuation.
  6. In many listed companies, the share price changes dramatically in relation to announcements, which will result in dramatic changes in the P/E ratio, although the earnings may not have increased.

If two companies in the same industry achieves the same NPAT, although they have different Balance Sheets in relation to equity/gearing levels, using the same P/E Multiple for both businesses results in the same equity valuation, which is incorrect.

The P/E Multiple should not be used to calculate either the business value or the equity value of both private and public (including listed) companies.