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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
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
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