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ACCA Strategic Professional · Advanced Financial Management · Valuation for acquisitions and mergers

Which statement best describes a limitation of valuing a target using the P/E ratio of a listed comparable company?

A key weakness of the P/E method is that the comparable's multiple embeds its own growth, risk and financial gearing, which may differ from the target's. Applying it directly can therefore mis-value the target. It does give equity value directly and is not limited by dividend policy.

  1. AIt ignores the capital structure and growth differences between the target and the comparable, which may make the multiple inappropriateCorrect
  2. BIt can only be used for companies that pay no dividends
  3. CIt always produces a value lower than the discounted cash flow value
  4. DIt values the entire enterprise before deducting debt, so it cannot give an equity value

Explanation

P/E reflects the comparable's growth prospects, risk and gearing, which may differ from the target's, so the multiple may not transfer. The P/E method gives equity value directly, is not restricted to non-dividend payers, and has no systematic relationship to DCF value.

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