Valuation is the buzzword in this startup culture. Startups are racing to join the elite club of $1 billion and get the status of Unicorns.
However, valuation is a tricky phenomenon and multiple ways exist to determine the valuation of a company, with P/E being the most popular one.
The price-to-earnings (P/E) ratio is one of the most commonly used metrics for valuing a company’s stocks. You can calculate the P/E ratio by dividing the current stock price by its earnings per share (EPS).
The P/E ratio is often used by investors for determining whether a stock is undervalued or overvalued. However, in most cases, the P/E ratio is not sufficient as a standalone metric for valuing a stock.
Here, I have provided detailed discussions to explore why the P/E ratio is flawed and why investors should not solely rely on this metric.
Shortcomings of the P/E Ratio as a Valuation Metric
As an ideal valuation metric, the P/E ratio has several shortcomings.
Understanding these drawbacks is important to avoid blunders in financial decision-making. Some of these shortcomings include the following:
1. Limited Assumptions
First, it’s important to understand that the P/E ratio is just one metric among many that investors can use to evaluate a stock. The P/E ratio demonstrates how much investors are willing to pay for each rupee of earnings.
However, it does not take into account the growth prospects of the company or its industry, balance sheet, cash flows, or any other factors that may impact its future earnings.
For example, a high P/E ratio may indicate that investors have high expectations for future growth. However, it may also mean that the stock is overvalued and that investors are paying too much for each rupee of earnings.
Conversely, a low P/E ratio may indicate that the stock is undervalued, but it may also mean that the company is facing headwinds that are depressing its earnings.
The P/E ratio can be misleading in certain situations. For example, companies with negative earnings may have an undefined P/E ratio because the denominator is negative.
This can make it difficult to compare the valuations of different companies. Additionally, the P/E ratio can be manipulated by companies that engage in accounting gimmicks or one-time events to boost earnings in the short term.
This decade, if not the century, is of startups. Most startup companies are in losses in the initial stages. In the pursuit of customer acquisition, marketing costs skyrocket and can lead to negative profits.
These companies spend years acquiring a market base before they start monetising their customers. You can pick up any 10 random startups and you will find that most of them are facing losses.
For instance, Cred reported losses of ₹1279 crores in the Financial Year 2021-22, with revenue of ₹442 crores. However, it has been valued at $6.4 billion in the international market. Technically, P/E ratio should not allow a valuation of even ₹1 with negative earnings!
Calculating the valuation of such companies using the P/E ratio is not possible. Revenue becomes an important component for the valuation of such startups but sadly, the P/E ratio does not consider revenue for valuation.
In such cases, other metrics come into play for determining the valuation of such companies.
3. Useful Only For Companies in the Same Industry
The P/E ratio is only useful when you are comparing companies that operate in the same industry. For example, a P/E ratio of 15 for a utility company may be considered high, but a P/E ratio of 15 for a tech company may be considered low.
This is because the growth prospects of these two industries are vastly different, and investors are willing to pay more for companies that have higher growth potential. Therefore, P/E is not that effective when it comes to comparing companies from different industries.
4. External Effect
The P/E ratio can be affected by external factors that are completely unrelated to the company’s underlying fundamentals. For example, changes in interest rates, market sentiment, or macroeconomic conditions can all impact the P/E ratio of a stock, even if the company’s earnings are stable.
This portrays that the P/E ratio is vulnerable and often fails to depict the true picture of the company in terms of its fundamentals and earnings.
Better Ways for Valuation Than PE Ratio
Given the flaws of the P/E ratio, what should investors rely on instead? Some of the metrics that investors may want to consider include the price-to-sales ratio, price-to-book ratio, and discounted cash flow analysis.
These metrics can help investors understand the underlying fundamentals of a company and make better and more informed investment decisions.
The price-to-earnings (PE) ratio is just one method for determining the valuation of a company. A variety of other methods can be used depending on the industry, size, and stage of the company. Here are some other ways to value a company apart from the P/E ratio:
Discounted cash flow (DCF) analysis: This method involves projecting a company’s future cash flows and discounting them back to their present value. DCF analysis is commonly used to value companies that have a consistent and predictable cash flow stream.
Price-to-sales (PS) ratio: This ratio is similar to the PE ratio. However, instead of using earnings, it uses the company’s revenue as the base measure. This ratio is often used for companies that are not yet profitable or have inconsistent earnings.
Enterprise value-to-EBITDA (EV/EBITDA) ratio: This ratio compares a company’s enterprise value (market capitalisation plus debt minus cash) to its earnings before interest, taxes, depreciation, and amortisation (EBITDA). This ratio is often used for companies that have a lot of debt or are in capital-intensive industries.
Dividend discount model (DDM): This model calculates the present value of a company’s future dividends. It is commonly used for companies that pay regular dividends.
Comparable company analysis (CCA): This method compares a company to similar companies in its industry to determine its value. This analysis typically looks at various financial ratios and multiples such as PE ratio, PS ratio, and EV/EBITDA.
Each valuation method has its strengths and weaknesses and no one method is perfect. Therefore, it is important to consider multiple valuation methods and use them in combination to arrive at a fair valuation for a company.
While the price-to-earnings ratio is a very renowned metric for valuing stocks, it may not make be suitable in most cases. The P/E ratio is just one of many tools used by investors to evaluate a company’s financial health and prospects, and it has its limitations.
Some of the reasons why the P/E ratio may not make sense include the fact that it can be easily manipulated by accounting practices, it does not take into account a company’s growth prospects, and it can be skewed by one-time events.
For getting a clear picture of a company’s valuation and for facilitating the comparison between two or more companies, it is important to take a holistic view and use multiple metrics instead of relying on a single one.
Each metric has its own assumptions and shortcomings. Considering multiple metrics will ensure that you get a clear picture of the current position of the company.