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### Course: Finance and capital markets>Unit 6

Lesson 4: Corporate metrics and valuation

# P/E conundrum

A situation where the price to earnings ratio seems to not fairly price an asset. Created by Sal Khan.

## Want to join the conversation?

• At , Sal talks about the P/E ratio being 10? How did he get the number 10? Did he just choose it (I remember in a previous video he said 10 was a nice round number for the P/E ratio)? Because I thought that you had to calculate the P/E ratio based on the P and the E.
• I think the confusion is that Sal was trying to show how just looking at P/E ration can skew the your analysis when you have two companies with different capital structures. If you wan t to show this how can you just randomly pick a P/E ration, when he was showing the Income he just picked 10. I'm confused by this, it would make sense if he said market price was x and so based on x P/E is y. Can someone please clear this up?
• There seems to be a structural mistake in this example. If a company has a relation of 900% Net Debt / Equity, the cost of debt would be huge, wich means that the net profit would be much, much smaller... and using the same P/E, the Market Cap of the second company would also be much smaller, meaning that the asset value calculated by "the market" is also much smaller than the first company.
• I believe he used this extreme amount of financing to end up with an extreme valuation difference. In real world applications, you are correct. However, the amount of overvaluation may not be as apparent. Also, companies have completely different capital structure mixes and growth fluctuations. Again, I believe the extreme amount of financing was just to easily show the fundamental problem with using solely p/e's.
• At , The whole confusion is because of the assumption to take P/E as 10 for both companies, which has totally different price/share( book value). Shouldn't they have different P/E ratios? i mean why consider same P/E ratio when they are likely to have different price/share( huge difference)??
• there is no such answer why people are ready to invest for such high p/e.. and there are plenty of individuals in market who does invest money without knowing b/s of companies.. they blindly follow rumors and invest their money in these stake expecting higher returns and creates demand which increases price of share.. after all . the only rule runs a market is demand and supply.
• For the second company on the right, why the asset is taken to be 100K and not 110K?
• It is 110 K of assets. The 10k is just cash on a bank account but it is stil assets of the company. The 10k is defined as non-operating assets.

Always compare the assets to the liabilities which in this case is 110K then the assets have to be 110K as well.
(1 vote)
• Both of the companies are paying 30% tax, question is why the second company is paying equal amount of tax beside having 100k dollars of debt?? second company should have more profit and it should enjoy tax benefit
• The two PLCs will pay the same amount of corporation tax unless they use tax avoidance schemes etc. The second company is paying the percentage of tax (30%) on a lower amount - which means they will pay a lower amount in tax. This is due to the "interest expense" also known as the tax shield, which reduces the amount of money that can be taxed.
(1 vote)
• Would using the price to book ratio give some light to such a misvaluation?
(1 vote)
• when there is 10k in cash on top of 100k asset, wouldn't that mean total asset is 110k instead of 100k?
• Yes. Company B has \$110K of assets. Remember A = L + E. Company B has \$100,000 in liabilities and \$10,000 in equity. In the video he lists the cash as distinct from the assets used to run the business, but they are both considered assets.
(1 vote)
• at wouldn't the net income for the first pizza place be 11k? Since 20k - 9k = 11k?
(1 vote)
• At , why does market value 189k means equity 10k instead of assets 100k?
(1 vote)
• what's the meaning of P/E Ratio: (Adjusted) ?
(1 vote)
• It depends on who is doing the adjusting. A popular measure is the Shiller P/E which is adjusted for the earnings cycle and inflation. A very simplified version would be to take the average earnings over the past 5 years to use as your E.
(1 vote)