Strategic corporate finance Essay Example | Topics and Well Written Essays - 2000 words - 1

Strategic corporate finance - Essay Example Price-to earnings ratios as a method of share valuation aids in the determination of whether a company is undervalued or overvalued, however, P/E ratio has a number of limitations or pitfalls and is only valid in specific circumstances. Its usefulness is undermined by the following factors. The first factor is accounting. Earnings from which is it derived is an accounting figure that is determined under the guidance of accounting rules known as Generally Accepted accounting Principles, GAAP) that are subject to change and they usually vary from one country to another (Barnhart & Giannetti 2009: 79). Therefore, EPS can be squeezed, twisted and prodded into numerous numbers depending on how one decides to do the books. It is therefore subjective and the figures being compared may not be the same. The second factor that limits the usefulness of P/E ratio is inflation. During times of high inflation, P/E ratio tends to e much lower because the market normally views the earnings as bein g artificially distorted upwards (Ball 2012: 327). During such times, depreciation as well as inventory costs tends to be understated since the replacement costs of equipment as well as goods increase with the rise in general level of prices. Information therefore, makes it hard to value the shares because past information is often less useful today. P/E ratio cannot therefore give a clear picture regarding the valuation of the shares of the company in times of high inflation Another limitation is about market interpretations. The values of P/E can be interpreted in a number of ways, for instance, a low P/E ratio may mean that the company is undervalued. On the other hand, it may indicate that the market thinks that the firm in question is headed for trouble or problems in the near future. This implies that the earnings of the company will reduce lower than expected (Ball 2012: 330). It is clear that companies are able to manipulate