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Why PE Is No Longer A Good Way To Value Shares

Long time readers of my blog will have realised by now that I love to use PE to value shares (with the exception of angel investment, because it’s more complicated). I have a very handy set of graphs I use to show the value in PE over time, which I use to discern what PE is appropriate for any given growth. I like this method because it’s quick and easy so I’m less likely to make a mistake. It’s also shortsighted, looking only a few years ahead, which is great because my experience of business tells me that predictions looking further than a year are guesses anyway.

Unfortunately, given the downward outlook for the economy, my graphs have become irrelevant as they all model positive trajectories. I contemplated making new graphs assuming negative growth, but figured that there’s no point without calculating future growth beyond the negative – otherwise where is the value in buying such a stock?

A poster on ShareTrader.co.nz (I think it might have been Winner69) stated that a PE valuation is just an abstraction of a DCF valuation (or words to that effect), and I wholeheartedly agree with that statement and it’s something I’ve opined to myself before, though I would append just two extra parts to that:

A PE valuation is an abstraction of a DCF valuation, that is shortsighted and only accounts for unidirectional growth at a constant rate.

Lewis Hurst

It is in this statement that belies the fault in using PE for valuations in the current stock market; growth will likely be neither unidirectional or constant.

Therefore I posit that presently some form of DCF valuation is a more appropriate way to value listed shares in the current market, though it’s also worth remembering that any valuation methodology would have to be selected / designed with your investment strategy in mind. On that note, I feel that dividend / income investors (such as myself) should also be considering value based on a DCF rather than potential dividend value, because as profits diminish and business risks increase, dividends can be cut disproportionately to the market value of the stock; hence a dividend based valuation could price you out of the market and cause you to invest later than you otherwise would, which would end up reducing your dividend yield.

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