PE Ratios and Earnings Growth

1
PE Ratios and Earnings Growth
Where We Are Going

• We examine the effect of earnings growth on the
  price/earnings ratio. We will learn how to use
  the adjust the price/earnings ration for growth
  rate differences between the target and
  comparable firms.

Chapter 17
2
How Expected Earnings Growth Affects PE Ratios

• Multiple valuation
• Must match on, or otherwise control for,
  variables that affect the valuation ratio.
• Usually cannot match perfectly, instead we match
  as closely as possible and then adjust for any
  differences that remain.

3
How Expected Earnings Growth Affects PE Ratios

• To deal with differences in expected earnings
  growth between target firms and comparable firms,
  we must develop a means to adjust for different
  earnings growth rates in a PE valuation

4
How Expected Earnings Growth Affects PE Ratios
Continued

• Assuming earnings and cash flow are equal and
  using forecasted current-period earnings as the
  value driver (E1)

the cost of equity
the markets current expectation of earnings in
period t
5
How Expected Earnings Growth Affects PE Ratios
Continued

• The higher the expected growth in the earnings
  series, the higher the PE
• Because as a greater proportion of firms value
  comes from future periods, the higher is the
  firms value relative to current period earnings
  and the higher the PE.

6
How Expected Earnings Growth Affects PE Ratios
Continued

• There are infinitely many variations in earnings
  growth patterns
• To simply our analysis
• Assuming earnings will grow at one rate for a few
  years and at another rate for all remaining years

7
How Expected Earnings Growth Affects PE Ratios
Continued

• Breaks the earnings series into two parts
• Short-term period of supernormal growth
• Long-term period of sustainable growth
• A firm cannot growth at a very high rate per year
  over a long period, because otherwise it would
  eventually account for most of the economy

8
How Expected Earnings Growth Affects PE Ratios
Continued
Value of earnings during supernormal growth period
Value of earnings during normal growth period
Numerator is the value of the firms
equity Denominator is earnings in the first year
Two-period Model PE Ratio
9
How Expected Earnings Growth Affects PE Ratios
Continued
The two-period model can be rewritten as
Value per dollar of earnings in first n period
(supernormal growth period)
Value per dollar of earnings beginning in period
n1 (sustainable growth period)
Compare to Equation 8.5 on pg. 176
10
How Expected Earnings Growth Affects PE Ratios
Continued

• The relationships described in the equation can
  help us understand how differences in expected
  earnings growth affect the PE ratio.
• Allow us to adjust a comparable firms PE for
  differences earnings growth before using the
  comparable firms PE to value a target firm.

11
How Expected Earnings Growth Affects PE Ratios
Continued

• Calculation of PE Ratio with Varying Expected
  Supernormal Growth Rates

Cost of equity 12 Normal growth rate 3 5
years at supernormal growth rate
12
PE and Supernormal Growth RatesTheoretical
Relationship

• PE Ratio versus Expected Supernormal Growth

45
.12
40
35
5
n
30
.03
g
25
PE Ratio
20
15
10
5
0
0.15
0.20
0.25
0.30
0.35
0.40
0.45
0.50
0.05
0
0.10
Expected Supernormal Growth Rate
13
PE and Supernormal Growth RatesTheoretical
Relationship Continued
Valuation Error Using PE Ratio When Expected
Supernormal Growth Rates Are Not Equal
45
.12
40
5
n
24.7
35
.03
g
30
25
PE Ratio
Valuation error
20
15
10
18.6
5
0
0.2
0.3
0.4
0.5
0
0.1
Supernormal Growth Rate
14
Actual PE Ratios and Supernormal Growth Rates

• Are PEs really related to supernormal growth
  rates empirically?
• Exhibit 17.4
• The distribution of points in Ex. 17.4 follows
  fairly closely the shape of the hypothetical
  plots in Ex. 17.2 and 17.3
• It shows that actual PE ratios are related to
  supernormal growth

15
Controlling for the Effect of Supernormal
Earnings Growth Rates on PE Analyses
Two ways to control Expected Supernormal Growth
Matching to Control for PE Difference
Adjusting for Supernormal Growth Rate Differences
16
Matching to Control for PE Difference

• One way is to match on industry, however. . .
• Firms in the same industry may still vary widely,
  eg. IBM vs. Dell
• How about match on a narrower definition of
  industry?
• The pool is smaller and it is even more difficult
  to find a comparable firm
• It is difficult to find a comparable firm that
  matches on growth characteristics perfectly

17
Adjusting for Supernormal Growth Rate
Differences The PEG Ratio
The PEG Ratio

• Allows us to start with a comparable-firm PE
  ratio, but then adjust it for the effect on the
  PE of differences in expected earnings growth
  rates
• Instead of assuming PE ratios are equal across
  firms, the PEG approach assumes the ratio of the
  PE to the growth rate is the same across firms.

18
The PEG Approach

• Using the expected supernormal growth rate in the
  ratio, assume that

19
The PEG Approach Continued

• This allows us to estimate the appropriate PE
  ratio for the target firm

Where PEG
20
The PEG Approach Continued
So, the target would be estimated by
21
The PEG Approach Continued

• Example in Exhibit 17.5
• Because the PEG ratio adjusts for growth
  differences, it significantly reduces the error
  caused by selecting comparable firms with
  different growth rates

22
The PEG Approach Continued

• The PEG ratio will be useful for valuing
  otherwise comparable firms with different
  supernormal growth rates as long as it is roughly
  constant across the different values of
  supernormal growth
• Exhibit 17.6 shows how the PEG ratio varies with
  the expected supernormal growth rate
• PEG curve gets very flat above gsn of about 20

23
PEG Ratio Not Helpful in Low-Growth Industries

• When supernormal rates are low, the PE ratio is a
  better choice than the PEG ratio
• The line is very steep at lower supernormal
  growth rate on Exhibit 17.6
• See example on the bottom of page 414 and also
  Exhibit 17.7

24
PEG Ratio Not Helpful in Low-Growth Industries
Continued

• When firms are not matched on long-term
  sustainable growth, the PE ratio can be used
  because it will usually not produce a large
  valuation error
• Because we expect most firms would fall in a
  fairly narrow rage close to the expected
  long-term growth rate in the economy, say from 2
  to 4.

25
Pitfalls in PEG Analysis

• Analysts use different growth rates in PEG
• Some use a longer-term sustainable growth rate
• Others use a short-term supernormal growth rate
• Still, others use an historical rate or are not
  clear about what growth rate they use
• It is important to consider how the ratio is
  defined and how the PEG varies with the growth
  rate used in the PEG definition

26
Summary
We have learned

• How expected earnings growth affects PE ratios
• Differences between supernormal and long-term
  growth rates

27
Summary Continued

• Ways to control supernormal growth
• The PEG Ratio
• Pitfalls in PEG analysis