PE ratio (or earnings-multiple) is very common being used in the valuation (including in the start-up valuation) regardless many finance scholars will suggest the use of Discounted Cash Flow (DCF) approach, but as you probably already know, that building a full set of projected Financial Statements is easier said than done. Additionally, discounting projected cash flows is about:
discounting EXPECTED CASH FLOWS with EXPECTED [OPPORTUNITY] COST OF CAPITAL
I bet you know as well that EXPECTED is not the same with REALIZED Cash Flows.
For example, if you put the card no. 1, 2, 3, 4 and 5 into a box, and doing thousands of drawings from that box, the EXPECTED card will be :
the Mean = (1+2+3+4+5)/5 = 15/5 = 3
But your reality will be either 1, 2, 3, 4, or 5, so 3 is just of them.
Ok, back to PE ratio.
The hard time for getting the Price of a stock at the end of Terminal period, let’s put it _t (t= terminal).
We could use (i) Direct Comparison or (ii) Direct Capitalization approach.
I guess, the most important is to understand the key drivers or factors that will impact the PE ratio, which I am trying to hand-write it as depicted below.
The conclusion, the P/E at terminal period is other things being equal, the investors should logically pay more for a stock with
- a higher potential growth (g); and
- lower required rate of return (r), and
- lower plowback ratio (b).