Page 33 - DIY Investor Magazine - Issue 23

HOW IS P/E USED TO CREATE A FAIR VALUE CALCULATION?
Fair value is a result of a valuation model that discounts profits or cashflows to shareholders at an appropriate discount rate and is represented as a share price, which reflects the risk of investment.
One approach to finding fair value, typically used in cyclical sectors, is to create a picture of trend earnings taken from either historic values, a trailing P/E, or from predicted values, a forward P/E. Trend earnings are then multiplied by average P/E to create fair value.
As fair value calculations use either future profits or cashflows to shareholders rather than historical business costs, the subsequent valuation is more relevant for analysts predicting a stock’s value.
WHAT ARE THE LIMITATIONS OF P/E?
Macroeconomic forecasts can distort P/E, as investors’ uncertainty over inflation or interest rates can cause them to change the structure of their portfolio.
When inflation or interest rates rise, the discount rate for company cashflows increases. As a result, a company’s valuation decreases, lowering its fair P/E.
Drops in market confidence drive share prices down but are not reflected in the underlying earnings of the company.
This can create an inaccurate picture or undervaluation of the company’s prospects.
P/E figures also do not reliably represent a shareholder’s expected return on investment, where a company with
a low P/E may be able to provide investors with more consistent and greater dividends than a company with
a high P/E. Investors use dividends and book value as a check against this limitation.
P/E can also be influenced by accounting policies for non-cash items such as depreciation and amortisation. It is therefore important to ensure the necessary adjustments are consistent when comparing companies on a P/E basis.
Finally, when comparing figures internationally, it
is important to note that differences in accounting standards can result in an artificially high P/E, where, for example, it is advantageous for a company to report lower net income for tax reasons.
Article originally published by Edison Investment Research, republished in The Property Chronicle.
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33 DIY Investor Magazine | Oct 2019