More than often, financial analysis using calculated financial ratios of different companies act as a measure of the financial performance in terms of profitability, market value, leverage and liquidity levels in operations. In most cases, price-earnings (P/E) ratio is used by investors to measure the market value of company’s viability in terms of investment relative to its earnings in the market (Davies & Pain, 2011). Considerably, as a market value measure price-earnings (P/E) ratio expresses the relationship between the market price of a share of common stock and the prevailing earnings per share. As a result, investors use the calculated value of price-earnings ratio as a gauge of future earning power of specific firm shares (Atrill & McLaney, 2011). Nevertheless, there is the need to consider other market value ratios including dividend cover, dividend yield and earnings per share as some experts consider price-earnings ratio as an obsolete way to value firms.
As a ratio that gives the market's expectations of future earning, price-earnings (P/E) ratio uses the present value of future expected earnings. Even though, price-earnings (P/E) ratio remain as one of the most widely quoted investors ratio as it gives market confidence based on recent earnings per share in relation to prevailing market share price it has shortcomings in its calculations as it involves developing economic assumptions for expected revenues(Atrill & McLaney, 2011). More significantly, calculation of price-earnings (P/E) ratio remains obsolete because it is based on the postulation that companies can earn a rate of return that is substantially higher than the cost of capital.
In addition, calculation of price-earnings (P/E) ratio does not recognize the effects of capacity expansion that is anticipated in the future taking into consideration increased levels of demand when market value of capital increases. More so, calculation of calculation of price-earnings (P/E) ratio based on expected earnings of the future ignores shifts in the cost structure and demand change in an industry as it quickly renders existing assets of a company obsolete (Black, 2009). As a result, there is an increased likelihood of overestimation that either indicate high growth opportunities or low growth trends. As a measure that relies on prevailing market prices, analysts who use price-earnings (P/E) ratio for valuation can only apply the method in publicly traded companies, as opposed to private companies. More notably, price-earnings (P/E) ratio remains relatively easy to establish in actively traded large-cap stocks, as compared to smaller, less liquid stocks that can attract infrequent share transactions.
Even as, price-earnings (P/E) ratio remain as an obsolete market value ratios dividend cover, dividend yield and earnings per share can alternatively be used to make fundamental investment decisions. This is because, dividend yield gives a measure of cash returns on shares in terms of cash dividends and capital growth even though, it can only be used on listed companies as it requires the prevailing share prices (Gowthorpe, 2011). On the other hand, dividend cover as a measure of market value gives the certainty of safety in dividends payments as it indicates how the company can pay the current level of dividends using the prevailing profits to be earned. In addition, the earnings per share measure assist in estimating the amount of potential dividend that is available per share as it remains published in the annuals accounts of companies as stipulated by the international auditing standards.
In conclusion, financial analysts and investors should use other market value ratios besides price-earnings (P/E) ratio in measuring the market value of company’s viability. As a result, investors should use the calculated value of price-earnings ratio and other market value ratios including dividend cover, dividend yield and earnings per share as a gauge of future earning power of specific firm shares.
Atrill, P. & McLaney, E. (2011) Accounting & Finance for Non-Specialists – 7th Edition.
Harlow, England New York: Prentice Hall Financial Times.
Black, G. (2009). Introduction to accounting and finance. Harlow, England New York: FT
Davies, T. & Pain, B. (2011) Business Accounting and Finance – 3rd Edition. Harlow, England
New York: Pearson/Financial Times Prentice Hall.
Gowthorpe, C. (2011) Business, Accounting & Finance – 3rd Edition. London: Thomson