There are two main reasons: PEE Ratio cannot show the value of stock comprehensively In some cases, there will be a fall or up of share prices because of some market fears about the economy even the company still has a stable situation. Sometimes, when there is economic crisis all over the world, there will be a fall in stocks price and value investor will buy the stocks in a large amount. Focusing on the PEE ratio Is a good way to make the decision on buying the stock. 2. PEE ratio could be meaningless to the decision
It Is very difficult to say whether a high or low PEE ratio Is good time for investment-The point is that we should find out that what is the cause of high PEE ratio or low PEE ratio. For example, a company has sold part of their brand to other firms and result in a strong earning. This increase PEPS greatly. However, the decrease in market price will be followed as a weaker performance will be foreseers. Overall , the stock price will decrease and it results in a lower PEE ratio. Let may mislead some of investors to buy the stock.
Apart from PEE ratio, Dividend Discount Model (EDM) will be a better way to value the stock price. The EDM model seeks to value a stock by using predicted dividends and discounting them back to their present value. The Formula of EDM is Dividend per share over discount rate minus dividend growth rate. Value of Stock = ODL Where, ; DIPS (1) = Dividends per share expected to be received in one year ; R = The required rate of return for the investment ; G = Growth rate in dividends = ROE x earnings retention (or 1 minus dividend payout ratio) By the information given , we an there calculate the stock price.
Assumptions: 1. The first big assumption that the EDM makes is that dividends are fix and are not likely to change in the future . This means it has a constant growth rate indefinitely. EDM requires forecast the future dividends. But even for steady, reliable, utility-type stocks, it can be tricky to forecast exactly what the dividend payment will be next year. For example , company will pay fewer dividends if they want more equity to expand. 2. Also, the dividend payment may grow as small but constant rate.
With its second approach,the equity of the company is considered to be perpetuity. Apart from this, it assumes dividends are the only way investors receive money from the companies and any re-investment would be ignored. Limitations: 1)Underestimation of the value of stock The EDM has a strict reliance on dividends means that the value of stock will be underestimated if the companies pay out less than they can afford and causing accumulation in the equity.