CASE STUDY:

The term ordinary share is usually applied to a share where the

holder has no priority in being a dividend or receiving a capital contribution

in the event of the firm going into liquidation. It is also widely accepted

that a share is more difficult to value in practice than a bond, for at least

three reasons. Firstly, the promised cash flows (Dividends) are not known in

advance with ordinary shares. Secondly, the life of the investment is

essentially forever. There is no maturity for an ordinary share. Thirdly, there

is no easy way to observe the rate of return that the market requires.

Nonetheless, as we will see, there are cases in which we can estimate the value

of the future cash flows for a share and thus determine its value by using

dividend based approaches (Ross et al, 2019).

An obvious problem with dividend based approach to share

valuation is that many companies do not pay dividends. A common approach is to

make use of the price-to-earnings ratio.

The price-to-earnings ratio or P/E is one of the most

widely-used stock analysis tools used by investors and analysts for determining

share valuation. In addition to showing whether a company's stock price is

overvalued or undervalued, the P/E can reveal how a stock's valuation compares

to its industry group or a benchmark like the S&P 500 Index.

Empirical research find that that firms with low price to

earnings ratios (value firms) earn higher stock returns in the long term than

high price to earnings firms (growth firms) (Houmes & Chira, 2015). They

also suggest that for high P/E firms, boards of directors and outside

shareholders are less likely to intervene since higher returns reflect

increased agency incentives (agency theory based) for value-creating managers.

The term ordinary share is

usually applied to a share where the holder has no priority in being a dividend

or receiving a capital contribution in the event of the firm going into

liquidation. It is also widely accepted that a share is more difficult to value

in practice than a bond, for at least three reasons. Firstly, the promised cash

flows (Dividends) are not known in advance with ordinary shares. Secondly, the

life of the investment is essentially forever. There is no maturity for an

ordinary share. Thirdly, there is no easy way to observe the rate of return

that the market requires. Nonetheless, as we will see, there are cases

in which we can estimate the value of the future cash flows for a share and

thus determine its value by using dividend based approaches (Ross et al, 2019).

An obvious problem with dividend based approach to share

valuation is that many companies do not pay dividends. A common approach is to

make use of the price-to-earnings ratio.

The price-to-earnings ratio or P/E is one of the most

widely-used stock analysis tools used by investors and analysts for determining

share valuation. In addition to showing whether a company's stock price is

overvalued or undervalued, the P/E can reveal how a stock's valuation compares

to its industry group or a benchmark like the S&P 500 Index.

Empirical research find that that firms with low price to

earnings ratios (value firms) earn higher stock returns in the long term than

high price to earnings firms (growth firms) (Houmes & Chira, 2015). They

also suggest that for high P/E firms, boards of directors and outside

shareholders are less likely to intervene since higher returns reflect

increased agency incentives (agency theory based) for value-creating managers.

QUESTION:

Identify and evaluate difficulties and limitations in using the PE ratio to value share.