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PE Ratios: What Are The Implications For Equity And Market Analysis

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Title: PE Ratios: What Are The Implications For Equity And Market Analysis


1
P/E Ratios What Are The Implications For Equity
And Market Analysis
  • Charles Rayhorn, Ph.D., CFP

2
Introduction
  • Difficult For Students And Practitioners To
  • Evaluate Companies
  • Evaluate Equity
  • Find The Value For The Market
  • Find The Required Discount Rate Of Return
  • P/E Ratios Will Help

3
Discounting
  • Present value is the basic theory behind P/E
    ratios.
  • Perpetuity
  • Bonds that never repay their principle and pay
    interest forever.
  • Common stock with no growth
  • Growing perpetuity
  • Common stock with constant growth

4
Basic Valuation Model
5
Stock Valuation Models
The Basic Stock Valuation Equation
6
Stock Valuation Models
The Zero Growth Model
  • The zero dividend growth model assumes that the
    stock will pay the same dividend each year, year
    after year.

7
Stock Valuation Models
The Constant Growth Model
  • The constant dividend growth model assumes that
    the stock will pay dividends that grow at a
    constant rate each year -- year after year.

8
Stock Valuation Models
  • Price is determined by
  • Where E0 and E1 are current and expected
    earnings, P0 is the current intrinsic value,
    which is assumed to be the market price

9
Stock Valuation Models
10
P/E
  • P/E expected is then

11
P/E
12
P/E(current)
13
P/E(current)
14
P/E and Equity (Security) Analysis
  • Proposed Methodology
  • Fundamental Accounting Ratio and Statement
    Analysis
  • Problems?Can they be fixed
  • One period forecast for earnings
  • Using methodology in Brigham or other corporate
    text
  • Multiply the P/E by next periods expected
    earnings
  • What to do with the P/E?
  • Adjust upwards if the problems identified are
    easily fixed

15
A Simple Valuation Model for Equity
  • A simple model of security analysis Many
    corporate finance books discuss accounting
    statements in one chapter and long term financial
    planning in another chapter, while investment and
    security analysis books do little with these
    issues in actually arriving at common stock
    values. Given the difficulty of using
    econometric models in producing multi-period cash
    flowsa methodology based on projected accounting
    statements seems logical. The first step in such
    an analysis would be to evaluate the accounting
    ratios from both a time and an industry
    (benchmark) dimension. If there are problems can
    they be fixed and how long will it take to fix
    themone, two, three, or more years? The next
    step would be to use a guess about next year's
    sales and then project next year's earnings
    incorporating any changes indicated by the
    ratios. At the same time you would adjust the
    P/E ratio upwards if problems are fixable. The
    last step would be to multiply the earnings
    projection by the P/E ratio (remember this is a
    present value interest factor) to arrive at an
    estimate of price. Appendix 1 gives an example
    of this methodology.
  • This same methodology can be used for discovering
    the total value for a company. The only
    difference is that once the price per share is
    calculated, simply multiply by the number of
    shares outstanding to get total equity value.
    Calculate the present value of the debt using the
    appropriate interest rates. Adding up the
    present value of the debt and the price (present
    value) of the equity will give the total firm
    value.

16
An Example
17
An Example
18
Example
19
Example
20
Example
21
Example
22
P/E and the Market Discount Rate
23
P/E and the Market Discount Rate
24
P/E(expected) or P/E(current)?
25
P/E(expected) or P/E(current)?
26
P/E(expected) or P/E(current)?
27
What Can We say about the P/E
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What Can we say about the Future P/E
  • Evidence of Mean Reversion
  • So stay tuned

37
WHAT DO P/E RATIOS SAY ABOUT COMPANIES?Early
Results
  • Data was collected from Standard and Poors
    Market Insight for the 10 year period beginning
    in 1991 for the Dow 30 companies. The ratios
    selected are
  • ROI (NET)Net Return on Average Investment.
  • ROE (NET)Net Return on Average Equity.
  • ROE (REL)Relative Net Return on Average Equity.
  • P/E (CLS)Price Earnings Ratio.
  • P/E (REL) Price Earnings Ratio Relative to the
    SP 500. P/CF (CLS)Price/Cash FlowClose.
  • Dividend Yield. .
  • Relative Dividend Yield. Book Value.
  • LTD/EQLong-Term Debt to Common Equity.

38
WHAT DO P/E RATIOS SAY ABOUT COMPANIES?Early
Results
  • Data was collected from Standard and Poors
    Market Insight for the 10 year period beginning
    in 1991 for the Dow 30 companies. The ratios
    selected are
  • CURRCurrent Ratio.
  • QUICKQuick Ratio.
  • INTCOVInterest Coverage.
  • TIETimes Interest Earned.
  • SALES Growth
  • EPS (BASIC)Growth.
  • Cash Flow--Growth
  • Inventory Turnover.
  • Receivables turnover.
  • Total Assets Turnover.
  • Net Profit Margin.

39
WHAT DO P/E RATIOS SAY ABOUT COMPANIES?Early
Results
  • The ratios were sorted from low to high and given
    a score of 1 to 30 (1 is low, 30 is high). Higher
    ratios are better.
  • Only the debt ratio is backwards.
  • The score for each company is the sum of the
    individual ratios ranking score.
  • Company with the highest score is the best
    while the company with the lowest score is the
    worst performing company.
  • The data scores were sorted from high to low
    along with the associated ratio data for 1991.
    The tri-tiles were then followed for the
    remaining years to see what happens to the
    ratios.
  • T-tests are performed on the various years to see
    if there is a significant difference in the
    means.
  • Tables 2a through 4e are presented at the end of
    this paper.

40
WHAT DO RATIOS SAY ABOUT COMPANIES?
  • Bad companies are associated with low P/Es
  • Good companies are associated with high P/Es
  • Bad companies get better and this is reflected
    in various ratios as well as the P/E
  • This implies that equity and firm valuation using
    a fundamentalP/E approach seems valid.

41
Conclusion
  • P/E multiples are adjusted present value factors
  • Thus using them in analysis is theoretically
    sound
  • P/E multiples along with fundamental analysis
    seems to be a reasonable valuation technique
  • P/E multiples can be used to find the Market
    discount rate
  • More work needs to be done

42
Other Approaches to Stock Valuation
Book Value
  • Book value per share is the amount per share that
    would be received if all the firms assets were
    sold for their exact book value and if the
    proceeds remaining after paying all liabilities
    were divided among common stockholders.
  • This method lacks sophistication and its reliance
    on historical balance sheet data ignores the
    firms earnings potential and lacks any true
    relationship to the firms value in the
    marketplace.

43
Other Approaches to Stock Valuation
Liquidation Value
  • Liquidation value per share is the actual amount
    per share of common stock to be received if al of
    the firms assets were sold for their market
    values, liabilities were paid, and any remaining
    funds were divided among common stockholders.
  • This measure is more realistic than book value
    because it is based on current market values of
    the firms assets.
  • However, it still fails to consider the earning
    power of those assets.

44
Stock Valuation Models
Free Cash Flow Model
  • The free cash flow model is based on the same
    premise as the dividend valuation models except
    that we value the firms free cash flows rather
    than dividends.

45
Stock Valuation Models
Free Cash Flow Model
  • The free cash flow valuation model estimates the
    value of the entire company and uses the cost of
    capital as the discount rate.
  • As a result, the value of the firms debt and
    preferred stock must be subtracted from the value
    of the company to estimate the value of equity.

46
Stock Valuation Models
Free Cash Flow Model
Dewhurst Inc. wishes to value its stock using the
free cash flow model. To apply the model, the
firms CFO developed the data given in Table 7.3.
47
Stock Valuation Models
Free Cash Flow Model
Step 1 Calculate the present value of the free
cash flow occurring from the end of 2009 to
infinity, measured at the beginning of 2009.
48
Stock Valuation Models
Free Cash Flow Model
Step 2 Add the PF of the FCF found in step 1 to
the FCF for 2008.
Total FCF2008 600,000 10,300,000
10,900,000
Step 3 Find the sum of the present values of the
FCFs for 2004 through 2008 to determine VC. This
is shown in Table 7.4 on the following slide.
49
Stock Valuation Models
Free Cash Flow Model
50
Stock Valuation Models
Free Cash Flow Model
Step 4 Calculate the value of the common stock
using equation 7.6.
VS 8,628,620 - 3,100,000 4,728,620
51
PEG
52
PEG
  • Actually the real numbers would be 100 times
    larger
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