An example will illustrate lamar company found upon

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: any remaining money were divided among the common stockholders.10 This measure is more realistic than book value—because it is based on the current market value of the firm’s assets—but it still fails to consider the earning power of those assets. An example will illustrate. Lamar Company found upon investigation that it could obtain only $5.25 million if it sold its assets today. The firm’s liquidation value per share therefore would be $5,250,000 $4,500,000 100,000 shares $7.50 per share Ignoring liquidation expenses, this amount would be the firm’s minimum value. 10. In the event of liquidation, creditors’ claims must be satisfied first, then those of the preferred stockholders. Anything left goes to common stockholders. A more detailed discussion of liquidation procedures is presented in Chapter 17. 334 PART 2 Important Financial Concepts Price/Earnings (P/E) Multiples price/earnings multiple approach A popular technique used to estimate the firm’s share value; calculated by multiplying the firm’s expected earnings per share (EPS) by the average price/earnings (P/E) ratio for the industry. EXAMPLE Hint From an investor’s perspective, the stock in this situation would be an attractive investment only if it could be purchased at a price below its liquidation value—which in an efficient market could never occur. The price/earnings (P/E) ratio, introduced in Chapter 2, reflects the amount investors are willing to pay for each dollar of earnings. The average P/E ratio in a particular industry can be used as the guide to a firm’s value—if it is assumed that investors value the earnings of that firm in the same way they do the “average” firm in the industry. The price/earnings multiple approach is a popular technique used to estimate the firm’s share value; it is calculated by multiplying the firm’s expected earnings per share (EPS) by the average price/earnings (P/E) ratio for the industry. The average P/E ratio for the industry can be obtained from a source such as Standard & Poor’s Industrial Ratios. The use of P/E multiples is especially helpful in valuing firms that are not publicly traded, whereas market price quotations can be used to value publicly traded firms.11 In any case, the price/earnings multiple approach is considered superior to the use of book or liquidation values because it considers expected earnings.12 An example will demonstrate the use of price/earnings multiples. Lamar Company is expected to earn $2.60 per share next year (2004). This expectation is based on an analysis of the firm’s historical earnings trend and of expected economic and industry conditions. The average price/earnings (P/E) ratio for firms in the same industry is 7. Multiplying Lamar’s expected earnings per share (EPS) of $2.60 by this ratio gives us a value for the firm’s shares of $18.20, assuming that investors will continue to measure the value of the average firm at 7 times its earnings. So how much is Lamar Company’s stock really worth? That’s a trick question, because there’s no one right answer. It is important to recognize that the answer depe...
View Full Document

Ask a homework question - tutors are online