Valuation of Sports Franchises: Discount Rate Calculation
In the previous article, we have already seen how the valuation of a sporting franchise can be found using the income approach. This approach relies extensively on finding out the cash flow that is likely to accrue to the sporting franchise and then discounting it at a predetermined discount rate in order to find out […]
Valuation of Sports Franchise: Replacement Cost Approach
In the previous few articles, we have already come across the income-based approaches that are used in order to value a sports franchise. We have also had a closer look at some of the shortcomings of the income-based approach. We are also aware that the income-based approach is not the only possible way to value […]
Treasury Inflation-Protected Securities (TIPS)
Investors who hold bonds generally earn a fixed nominal rate of return. However, the nominal return that they earn is in turn composed of two parts. One part compensates the investors for the inflation which has increased in the external world while their money has been locked in the security. The second part is the […]
Peer to Peer (P2P) Business Model
The internet has enabled the functioning of various new types of business models. The peer-to-peer business model is one such business model which has recently come into existence. Companies such as Outdoorsy and BlaBlaCar have transformed the way in which individuals and small businesses interact with one another. LinkedIn is one of the biggest names […]
Why Startup Companies are Staying Private?
Once upon a time, a successful IPO was considered to be a transition point for a startup company to be recognized as a full-fledged public company. The goal of every startup company was to finally go public on a reputed stock exchange. The only startup companies which did not want to go public were the […]
The price to earnings ratio is the most fundamental of all market related ratios. It has been used for decades by stalwarts in the investment community. However, it is also the ratio that has come under maximum fire from the skeptics. A variety of measurements have been developed to compensate for what skeptics call the lack of correct information provided by the price earnings ratio. Almost all other market related ratios are a variation of the price to earnings ratio.
Price to Earnings Ratio = Current Market Price / Reported Earnings of the Company
The price to earnings ratio tells the investors how many rupees they are paying for every rupee in earnings that the company presently has. If the price to earnings ratio is 5, then investors are paying 5 rupees to get a stream of earnings of 1 rupee per year till perpetuity. This ratio therefore also implicitly tells the payback period which in this case would be 5 years.
There are a lot of assumptions that the price to earnings ratio implicitly makes. This is the reason that this ratio has come under a lot of criticisms from skeptics who think that price to earnings ratio provides a distorted image of what the reality of the company really is. The common assumptions are as follows:
The world is yet to see a company that has been able to generate stable earnings for an extended period of time. This is why the price earnings ratio may present reality to be different than what it really is.
Moreover the investment community may not enough data at hand to adjust these earnings and arrive at a figure which they think are fair earnings of the company. Hence, naive investors who only look at price-earnings ratios without looking at whether the earnings have been manipulated will possibly make wrong decisions based on this number.
The price to earnings ratio must be interpreted in the light of the fundamentals of finance. These fundamentals are the fact that an investment grows over a period of time. This growth pattern usually follows an exponential pattern which makes the phenomenon of compounding so important.
The fact that price to earnings ratio uses simple arithmetic division makes it unacceptable to many skeptics in the investment community.
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