Title: PE Ratios: What Are The Implications For Equity And Market Analysis
1P/E Ratios What Are The Implications For Equity
And Market Analysis
- Charles Rayhorn, Ph.D., CFP
2Introduction
- 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
3Discounting
- 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
4Basic Valuation Model
5Stock Valuation Models
The Basic Stock Valuation Equation
6Stock 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.
8Stock 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
9Stock Valuation Models
10P/E
11P/E
12P/E(current)
13P/E(current)
14P/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
15A 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.
16An Example
17An Example
18Example
19Example
20Example
21Example
22P/E and the Market Discount Rate
23P/E and the Market Discount Rate
24P/E(expected) or P/E(current)?
25P/E(expected) or P/E(current)?
26P/E(expected) or P/E(current)?
27What Can We say about the P/E
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36What Can we say about the Future P/E
- Evidence of Mean Reversion
- So stay tuned
37WHAT 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.
38WHAT 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.
39WHAT 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.
40WHAT 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.
41Conclusion
- 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
42Other 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.
43Other 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.
44Stock 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.
45Stock 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.
46Stock 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.
47Stock 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.
48Stock 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.
49Stock Valuation Models
Free Cash Flow Model
50Stock 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
51PEG
52PEG
- Actually the real numbers would be 100 times
larger