The Four Stages of Evolution in Equity Share Valuation: 3.Price Earnings Multiple Method- The Concept, Trigger and Limitations

A key ingredient that ensured the growing success of companies is the evolution in valuation of shares that permitted shareholders to sell and investors to buy shares without diluting any of the economic advantages of ownership.

The evolution of share valuation is episodic, marked by stock market bubbles and often a major scandal that highlighted the limitation of the valuation method used which burst the bubble. The first of the four methods is the Dividend Capitalization method that evolved in the 18th century, followed by the Book Value method of the 19th century and the Price-Earnings Multiple of the 20th century. The 21st century saw the advent of dotcom/internet companies with long gestation periods that gave rise to the technique of valuing even loss-making entities with potential.

This is the third article in this series that captures the concept, the trigger and the limitations of the Price Earnings Multiple method. In the next article, the concept, trigger and limitations of the valuing loss making entities with potential will be described.

The Concept

18th century saw the first phase where equity shares were valued based on past performance as reflected by their dividend paying track record. In the second phase of equity shares valuation in the 19th century, shares were valued using book value, reflecting their present liquidation value. 20th century saw the third phase, where the focus shifted from the past and present to the future, where equity shares valuation was linked to future profit earnings. Higher the growth in expected future profits, higher was the price paid for a companies’ current earnings. Price Earnings Ratio reflected not just the relationship between price and earnings, but more important it reflects the future profit earning potential of the company.

The First of First

In 1906, Sears Roebuck & Co, wanted to raise capital for constructing a large mail order warehouse and working capital needs. They approached Goldman Sachs, who suggested an IPO for raising the capital. Goldman Sachs along with Lehman Brothers underwrote the $10 million stock issue, which consisted of preference shares of $5 million, that was backed by assets and another $5 million of equity shares that was backed only by goodwill. In those days, the preference shares were sold to public and the equity shares retained by the underwriters.

In the Sears Roebuck equity offering, Henry Goldman made a departure by offering the equity shares to the public and proposed the logic that ‘the value of a retail business should be calculated based on the rate at which it turned over its inventory, or how rapidly it generated cash. This, not the value of its physical assets, would determine its ability to meet debt obligations and secure a profit.[i]” With this powerful logic, he outlined the rationale for valuing companies with low capital base and high profitability where profit earning ability of the company became the basis for valuing equity shares.

The advent of profit as a basis for valuing equity shares resulted in profit per share being computed. Profit per share or its American version EPS the acronym for earnings per share became the focal point for investors. With EPS as the denominator, Price Earnings ratio or PE ratio became the equity market valuation buzzword.

Lessons Learnt

A single number that tells a story has its value in mass communication, especially if the communication is of a technical nature. As with any summary, Price Earnings ratio too when used as a standalone measure for comparing companies has significant limitations as it masks the two vital elements:

  • The quality of profits -while measuring the quantity of profits, it ignores the quality of profits-conservative accounting increases the quality of profits while aggressive accounting dilutes the quality.
  • Quality of governance: good governance could temper the market expectations by providing more conservative growth estimates thereby dampening the market expectations.

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