Covered Bonds
Asset-backed securities have become famous all over the world in the past few years. The largest market for asset-backed securities was in the United States of America. The sub-prime mortgage exposed the flaws inherent in the process of issuance of asset-backed securities. The world had been looking for an alternative to asset-backed securities. This is […]
Involvement of the Franchisor in Debt Funding
In the previous article, we have already seen that it is common for sporting franchises to raise significant amounts of debt funding. We also know that there are certain special characteristics of sports franchises that need to be taken into account before giving out loans to them. One more such important characteristic of debt funding […]
How do Commercial Banks Help in Processing Payments?
Timely payments are very important to any corporation. Only if a corporation is able to keep its word and make on-time payments to vendors, does it get the best terms from these vendors. Traditionally, making timely and correct payments was a big cost for large corporations. This is because these corporations have to process thousands […]
Nominal and Real Value of Money
The previous article was an introduction about the two basic decisions that corporate finance helps a corporation in making. Prima-facie, these two decisions may look pretty simple. After all everyone raises money in their daily lives and puts it to productive use. Simple accounting can tell us whether or not we should make those financing […]
Disadvantages of Banking as a Service
Banking as a service is set to transform the commercial banking industry. It is the latest buzzword in the commercial banking industry and almost every well-known commercial bank is allocating billions of dollars from its budget to get this model implemented at the earliest. This is because there are several advantages to implementing banking as […]
The price to earnings ratio is the most fundamental of all market related ratios. It has been used for decades by stalwarts in the investment community. However, it is also the ratio that has come under maximum fire from the skeptics. A variety of measurements have been developed to compensate for what skeptics call the lack of correct information provided by the price earnings ratio. Almost all other market related ratios are a variation of the price to earnings ratio.
Price to Earnings Ratio = Current Market Price / Reported Earnings of the Company
The price to earnings ratio tells the investors how many rupees they are paying for every rupee in earnings that the company presently has. If the price to earnings ratio is 5, then investors are paying 5 rupees to get a stream of earnings of 1 rupee per year till perpetuity. This ratio therefore also implicitly tells the payback period which in this case would be 5 years.
There are a lot of assumptions that the price to earnings ratio implicitly makes. This is the reason that this ratio has come under a lot of criticisms from skeptics who think that price to earnings ratio provides a distorted image of what the reality of the company really is. The common assumptions are as follows:
The world is yet to see a company that has been able to generate stable earnings for an extended period of time. This is why the price earnings ratio may present reality to be different than what it really is.
Moreover the investment community may not enough data at hand to adjust these earnings and arrive at a figure which they think are fair earnings of the company. Hence, naive investors who only look at price-earnings ratios without looking at whether the earnings have been manipulated will possibly make wrong decisions based on this number.
The price to earnings ratio must be interpreted in the light of the fundamentals of finance. These fundamentals are the fact that an investment grows over a period of time. This growth pattern usually follows an exponential pattern which makes the phenomenon of compounding so important.
The fact that price to earnings ratio uses simple arithmetic division makes it unacceptable to many skeptics in the investment community.
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