The P/E ratio method for credit score estimation
The P/E ratio method is probably the most widely used valuation method for businesses of all sizes, both public and private. This method values a business as a whole by capitalising its future maintainable after-tax real profits to arrive at total value, rather than by valuing goodwill and net assets separately as is done through the super profits approach. Thus, in a P/E ratio method the total value includes goodwill value. A P/E ratio is a way of expressing the capital value of an investment. If you receive a return of £25 on an investment with a capital value of £200, to calculate the percentage yield you divide the return by the value of the investment and multiply it by 100: (25 -4- 200 x 100) = 12.5%. Conversely, if you know the value of the return (£25) and the yield you wish to achieve in an investment (12.5%), you calculate the value you would place on such an investment by multiplying the return (£25) by a P/E ratio or multiple. The multiple is arrived at by dividing 100 by the percentage yield (12.5). In our example, the P/E ratio would be 100 -f 12.5 = 8. If the yield you were looking for was 15% your P/E multiple would be 6.66, and so on.
The concept of the P/E ratio method is simple, but there are practical difficulties with private businesses (especially smaller ones) in establishing the future maintainable profit (FMP) and in deciding what P/E ratio to use in each case. (Note that assets that are not used to generate the business income – known as ‘surplus assets’ – including such things as business premises, or other real estate owned by the business, are not included in the total business value calculated by using this method.)
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