Question 11.S-tQ.5: Discuss the use of the P/E ratio and dividend growth methods...
Discuss the use of the P/E ratio and dividend growth methods of determining the value of a target company.
Using P/E ratios to value companies is a rough rule of thumb and must be used with caution. EPS is an accounting figure that can be subject to manipulation and creative accounting. In addition, earnings will vary over time and not stay at their current level, so the EPS figure may need to be normalised to reflect this. Problems with using the P/E ratio method include the difficulty of selecting an appropriate P/E ratio to apply, and the fact that the ratio combines a current value (share price) with an historical value (EPS).
The accuracy of the dividend growth model relies heavily on forecast future dividend payments and the calculated shareholders’ required rate of return. Both of these figures are difficult to estimate with any accuracy. There are also difficulties in using the model in this context because it considers the dividends that flow to individual investors, rather than the company’s ability to generate cash flows from its assets.