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Hello, i am having issue in this chapter,
there are three main ways of calculating market capitalisation, either P/E ratio or DGM or Net assets method.Now i want to ask if a theoratical question comes up after asking to calculate values using these three and question is something like state reasons why each of those methods produced a different answer from one another.
can you please please highlight main points about why would each of those methods produce different answers and what do they reflect?
The problem with the dividend growth formula is knowing what dividend growth shareholders are expecting (and assuming they are expecting constant growth).
The problem with net assets is as to what figures to use (balance sheet values? realisable values?) and also how to value goodwill.
PE ratio is a practical approach (because PE’s are published) but the problem is finding companies with similar expectations of growth. Also, you would expect an unquoted company to have a lower value than an unquoted company, because the shares are less easily traded.
Thanks 🙂
Can you please tell what does P/E ratio reflect and what exactly is it?
and it’s importance when valuing business compared to other methods?The PE ratio is the market value per share divided by the earnings per share.
A higher PE ratio suggests that the shareholders are expecting higher growth (because then they are prepared to pay more for the share, which leads got a higher PE)
The reason it is important is that it is practical, and other methods have the problems a listed in my previous post here.
Thanks, just want to verify that if a company’s P/E ratio is lower then industry average, that means that there is room for improvement if management is capable of doing so (following an acquistion)? That’s what is written in most of the examiner solutions.
Thats true – because currently it is expected to grow at a lower rate than the rest of the industry.
Is the dividend yield method method also a main way of valuing market capitalisation? Should it give similar results to the P/E method, given that it is the reciprocal? Should we always incorporate growth into the dividend yield calculation, if the growth rate is known?
Thanks!
I think you mean earnings yield!
Dividend yield is dividend per share as a percentage of market value and is not the reciprocal of the PE ratio.
Earnings yield is the earnings per share as a percentage of the market value, and no – you do not take into account growth (for the same reason as you do not with PE valuations).
Sorry, I did mean earnings yield!
The reason I mentioned it, I think I saw in one of the answers that they had two possible results, one of which included growth, similar to the dividend growth model. I’ll see if I can find it, and of course I could be mistaken!
Thanks for your help.
I’ve found the relevant question now. It’s from question 3 from the December 2011 exam, question (a), part (iii).
The earnings is 66.6m, the earnings growth rate is 5%, and the earnings yield is 11%.
In the answer is states P0 = (66.6 x 1.05) / (0.11 – 0.05) = 1,165.5m.
It also states that alternatively the earnings yield could be given without growth.
No – the answer does not say that it could be given without growth.
The examiners answer shows 66.6/0.11= 606
He then says that you could incorporate growth into it and allowed an alternative answer. However, although he allowed it, strictly when using either earnings yield or PE ratio growth should be ignored in the arithmetic.
Sorry, I was referring to the answer given in my BPP practice and revision kit! I assumed that the answer here would be identical to that given by the examiner.
In the BPP book they give the calculation with growth first, then underneath they say “Note: Alternatively the earnings yield could be given without growth ie 66.6/0.11 – $605.5 million”.
It goes without saying, but naturally I accept your explanation (which or course concurs with the examiner’s answer). Thanks again for your help. Maybe I should complain to BPP for getting it wrong!
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