Essay on Discounted Cash Flow

Submitted By jayd101201
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Valuentum Financial Advisor Insights

Brian Nelson, CFA

President, Equity Research c - +1 (708) 653-7546

Thinking about the Price-to-Earnings
Ratio in a Different Light
The P/E Multiple Is Not as Basic as You Might Think
March 12, 2012

Executive Summary: We break down the key components of a price-toearnings multiple and highlight some of the pitfalls investors may encounter by using it incorrectly in the valuation process.
What is the purpose of such an article? The P/E ratio is so simple, right? It is just the price of the stock divided by the annual net diluted earnings per share of the firm. And the forward P/E is merely the price of the stock divided by next year’s annual net diluted earnings per share of the firm. The P/E is probably the most common measure to help investors compare how cheap or expensive a firm’s shares are, as stock prices for lack of a better term are arbitrary. For example, firms like Warren Buffett’s Berkshire Hathaway (BRKA), which has never split its stock, have traded as high as $140,000 per share, while other well-known companies like Sprint (S) can trade for just a few bucks per share. And Citigroup (C) was once a penny stock before its 10to-1 reverse split in 2011.
It’s only when investors compare a firm’s share price to its diluted earnings per share that they have any idea whether a company’s shares are expensive
(overvalued) or cheap (undervalued). The higher the P/E, the more expensive the company’s stock – and vice-versa. This seems way too simple, so why would we (or better yet, how could we) devote a whole paper to talking about such a basic financial concept. Well, the truth is that the P/E ratio is not as basic as you might think (and even some of the most seasoned investors don’t understand what this powerful multiple means).
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Index™ considers a company’s forward P/E ratio by comparing this measure to that of its industry peers to determine if the company is trading at a

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comparatively attractive valuation. If the P/E is lower than its peer median, an investor is paying less per unit of earnings than the median of its peer group.
Investors are getting a good deal in this case, all else equal, right? Well, the

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2 problem is that companies are never equal, and even comparisons among firms that are in the same industry can be misleading. It is also inappropriate for investors to apply a firm’s historical median (or average) price-to-earnings ratio to the same firm’s future earnings stream. But why not? It’s the same stock. Shouldn’t it be relevant and applicable? Well, yes and no. First, it’s great for investors to have an idea of what “multiple range” a company has traded at in the past – there’s lots of value to this, and most relevant for cyclical firms (mainly industrials) that may, from a fundamental standpoint, exhibit similar (but not identical) patters with respect to both earnings and their P/E through the course of each economy cycle: think Boeing (BA) and the commercial aerospace cycle; Ford (F) and consumer demand for auto sales; or United Continental (UAL) with respect to premium air travel demand. But for less-cyclical firms (and even for cyclicals where structural industry dynamics have altered over time), investors are wrongly assuming that the forward outlook of the past (which determined the historical multiple) will be the same as the forward outlook of the present (which determines the current multiple). This, unfortunately, is never true.
So what is an investor to do? We know that it’s imperfect to compare a firm’s current or forward price-to-earnings ratio to its peers or even to the median…