MA514: Business Finance - The Price-to-Earnings Ratio - Finance Assignment Help

Assignment Task:

Unit Learning Outcomes Addressed:

a. Demonstrate strong conceptual corporate finance knowledge to analyse and interpret advances in theory for professional practice.
b. Communicate relevant high-level finance knowledge with other professionals.

Assessment Task Description
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 finds 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) (Homes & 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.

Required:
You are required to critically examine the price-to-earnings ratio used for share valuation and identify difficulties and limitations in using the PE ratio to value share.

In your report:
1. Critically analyse the price-to-earnings ratio used for share valuation.
2. Identify and evaluate difficulties and limitations in using the PE ratio to value share.
3. Examine how a higher stock price reinforces agency incentives associated with the alignment of interests between managers and shareholders, arguments drawing on Agency theory.

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