P/E Ratio Stock Valuation: Understanding Implicit Assumptions

Imagine you are trying to figure out the price of a house in your neighborhood. One common approach is to look at recently sold houses that are similar to yours, maybe in terms of size, number of bedrooms, and location. You might calculate the average price per square foot of these comparable houses and then apply that average to your own house to get an estimated value.

Using the average Price-to-Earnings, or P/E ratio, of comparable companies to value a stock works in a surprisingly similar way. The P/E ratio is simply the company’s stock price divided by its earnings per share. It essentially tells you how much investors are willing to pay for each dollar of a company’s earnings. When we use the average P/E of comparable firms to value another company, we are implicitly making several key assumptions.

The most fundamental assumption is comparability itself. We are assuming that the companies we are using as benchmarks, the comparable firms, are genuinely similar to the company we are trying to value. Think back to the house analogy. If you are trying to value a modern, newly renovated house, it wouldn’t make much sense to compare it to very old, dilapidated houses, even if they are in the same neighborhood. Similarly, in the stock market, we must ensure that the comparable companies operate in the same or very similar industry, face similar economic conditions, and have comparable business models. For instance, if you’re valuing a software company focused on cloud computing, comparing it to traditional brick-and-mortar retailers wouldn’t be appropriate, even if they happen to be of similar size.

Another crucial assumption is that the market is reasonably efficient in pricing the comparable companies. We are trusting that the stock prices of these benchmark companies accurately reflect their intrinsic value, or at least are not significantly mispriced. If the comparable companies are overvalued or undervalued by the market, then using their average P/E ratio will lead to a similarly skewed valuation for our target company. It’s like assuming the recently sold houses in your neighborhood were all sold at fair prices. If there was a sudden housing bubble that inflated those prices, using those inflated prices as a benchmark would overestimate the true value of your house.

We also implicitly assume similar growth prospects. P/E ratios are heavily influenced by expected future growth. Companies with higher expected growth rates generally trade at higher P/E ratios because investors are willing to pay more today for the promise of greater earnings in the future. Therefore, when using comparable P/E ratios, we are assuming that the target company has a similar growth trajectory to the average growth expected of the comparable firms. If the target company is expected to grow much faster or much slower than its peers, simply applying the average P/E ratio might be misleading. Imagine if your house has the potential for significant expansion or is located in a rapidly developing area, while the comparable houses are in a stagnant neighborhood. Their current prices may not fully reflect the future potential that your house possesses.

Furthermore, we are assuming similar risk profiles. Riskier companies typically trade at lower P/E ratios compared to less risky companies, even within the same industry. This is because investors demand a higher return to compensate for the increased uncertainty associated with riskier investments. When using comparable P/E ratios, we assume that the company we are valuing has a similar level of risk, whether that’s financial risk, operational risk, or industry-specific risk, to the average risk profile of the comparable companies. If the target company is significantly riskier, applying the average P/E ratio might overvalue it. Think of comparing a house in a quiet, safe suburb to one in an area with high crime rates. The riskier location would generally command a lower price, even if the houses are otherwise identical.

Finally, there’s an implicit assumption of consistent accounting practices and earnings quality. P/E ratios are based on reported earnings. If companies use different accounting methods, or if the earnings of the comparable companies are not of high quality, meaning they are not sustainable or are manipulated, then the P/E ratios may not be truly comparable. We assume that the earnings figures used to calculate the P/E ratios are based on similar accounting standards and reflect the true underlying profitability of the businesses. If some comparable companies are using aggressive accounting to artificially inflate their earnings, their P/E ratios might appear lower than they should be, leading to an inaccurate valuation when applied to a company with more conservative and transparent accounting.

In essence, using comparable P/E ratios is a shortcut valuation method. It relies heavily on the idea that similar companies should trade at similar multiples. While it can be a useful starting point, it’s crucial to remember these underlying assumptions and critically evaluate whether they hold true in each specific case. Failing to do so can lead to inaccurate valuations and potentially poor investment decisions. It’s always wise to dig deeper and consider other valuation methods and factors beyond just a simple P/E ratio comparison.