Equity valuation query

deepakkrkanodia
Finance Junkie
Posts: 49
Joined: Thu Aug 09, 2012 4:45 pm

Equity valuation query

Postby deepakkrkanodia » Thu Nov 22, 2012 5:44 pm

Q The statement in P/E ratio fundamental comparison states “The higher the level of debt, indicates that the company has higher risk and a higher required return on equity, which supports that the company having a lower P/E ratio than the industry”.

Query: If a company has higher level of debt, then its interest expenses too will be higher, resulting in lower earnings and if earnings are lower, the return on equity will be lower.
So how the company will have lower P/E ratio than industry, it should have higher P/E ratio than industry due to decreased earnings.

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sujithmeno
Posts: 8
Joined: Sun Jun 24, 2012 8:00 pm

Re: Equity valuation query

Postby sujithmeno » Sun Nov 25, 2012 7:34 pm

Intuitively, the price is basically the discounted cash flow of future earning, and when debt increases the earnings tend to decrease for multiple years due to int. exp & the WACC increases. This impact on price should be very stronger than the onetime downside impact of lower earnings considered in the PE multiple. (assuming everything else to be constant).

deepakkrkanodia
Finance Junkie
Posts: 49
Joined: Thu Aug 09, 2012 4:45 pm

Re: Equity valuation query

Postby deepakkrkanodia » Mon Nov 26, 2012 3:33 pm

so does it mean, that lower P/E multiple is due to lower earnings forecasted as well as lower stock price (lower stock price is due to higher wacc taken for discounted future cash flows)?

sujithmeno
Posts: 8
Joined: Sun Jun 24, 2012 8:00 pm

Re: Equity valuation query

Postby sujithmeno » Tue Nov 27, 2012 9:47 pm

The point is that the impact of the increased funding cost would be higher on the numerator than that of its impact on denominator.

Try to do an hypothetical problem and plug in the values in various equations to arrive @ price with appropriate earning measure.


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