Equity Valuation: Models from Leading Investment Banks

10

Where Does Accounting Go Wrong?

It is possible to relate the P/E ratio to a DCF model for a mature, stable firm. Consider the fundamental equation for a P/E multiple below. Its implications illustrate that a simple P/E ratio contains a number of accounting and valuation deficiencies. The forward P/E¹ can be calculated for a firm with constant earnings growth, g, and a constant perpetual return on equity, ROE. The term r_E represents the cost of equity.

Critical readers are doubtless wondering how many firms meet these restrictive conditions. To make matters worse, accounting dependencies and deficiencies are manifold. Earnings and the subsequent ROE can be altered by any number of accounting decisions:

• Asset aging and depreciation policy (changing earnings through the depreciation charge and net assets through accumulated depreciation);
• Leasing of assets (thereby removing the asset from the balance sheet and increasing operating expenses on the income statement);
• Leverage and financial structure (thereby altering the amount of equity on the balance sheet);
• Historical acquisitions and goodwill amortization policy (altering both income statement and balance sheet);
• Timing of expenses and revenue (altering both income statement and balance sheet through the level of accruals).

Note how important ROE is to the P/E ratio. Earnings quality should be an intrinsic consideration when ...