2.4
Some problems with the P/E ratio
What earnings to use? Accounting methods can be
dierent.
Small problem: need to adjust for short-term "noise".
Standard is to do TTM (trailing-twelve-months) methods.
P/E ratios cant be aggregated like betas in a po
A
P
$100
E
$10
P/E 10
B
$150
$30
5
C
$300
$10
30
D
$30
$0.01
-3,000 or n/a
If we use the rst 3 rms, the average P/E is 15.
If we use all, the average P/E is 739.
If we add 10 cents of earnings to D, then the
average is 86.25. Still not representative o
3
Perspective on the P/E ratio and
other comparables
What rm is a good comparable? Are Pepsi and
Coca-Cola really comparable? Yes and no. It depends on your judgement and the particular project
under study.
At the end of the day, comparables are a matte
There are innite ratios. Go on line and look them
up.
Some ratios seem very arbitrary, others make more
sense to nance professors. E.g., value per bed in the
hotel industry? Think about the nasty incentives this provides.
Comparables usually have simil
Today:
1. Cash-ow rights and control rights.
2. Measuring leverage.
3. Leverage irrelevance of Modigliani and Miller.
4. WACC in an M&M world.
5. Perspective on M&M
Readings: Chapters 15 and 16 Welch
Assignment 6 due next Monday 11/24
In this class:
What makes debt dierent from equity?
Do corporations around the world issue similar types
of securities?
Is the ownership structure of typical U.S. rms the
standard around the world?
What is leverage?
Why can leverage be irrelevant for
1
Cash-ow rights and control rights
The nancial instruments issued by a rm assign two
basic rights:
Cash ow rights: how much and in what order
claimholders get paid.
Control rights: who takes decisions with respect
to the use of the assets of the compa
Control rights: shareholders vote. Shareholders are the "owners". Usually 1-share/1-vote in
Anglo-Saxon markets, by law or regulation of the
exchange.
In other markets it is often the case that there are several
"classes" of shares for the same company,
Sometimes it is useful to see these securities in payo
diagrams: payo as a function of the value of the
total value of the rm
Payo to debt is at after its face value has been
covered.
Equity gets the upside. It looks like a call option.
Convertible bo
Control rights: most of the time debtholders have
little inuence over how a rm is managed ("armslength" nancing). But debtholders can force
bankruptcy and gain more control over the assets of the rm (Also, covenants).
The Japanese or German model is ver
Now rare in public companies.
Cash-ow right: somewhere between debt and
equity.
Control right: not in general.
Tax status: with better treatment of dividends
for ordinary shares preferred equity is becoming
less important.
Stock options: granted to C
So, when the P/E ratio of the market moves it is
because expected returns (aka the cost of capital,
aka discount rates) are moving.
A high P/E ratio for the market suggests low expected returns, i.e., expect prices to go down. This
is what happened afte
2.3
The stock market boom of the 1990s
Internet stocks in the 1990s give us a great example
of how useful the P/E ratio can be for our analysis.
This example is based on Ofek and Richardson (Journal of Finance 2002)
In 1999 the P/E ratio of a typical i
Today:
1. Intuition for using comparables/multiples.
2. The P/E ratio.
3. Perspective on the P/E ratio and other comparables.
Readings: Chapter 14 Welch
Assignment 5 due next Monday 11/17
In this class:
Multiples as a short-cut or quick-and-dirty NPV.
What does the price-earnings ratio tell us?
What is a "normal" P/E ratio?
Could the stock market crash of the year 2000 have
been predicted with P/E ratios? (Bob Shiller did).
Does it ma
1
Intuition for using comparables
The question is still the same: how do we value
projects and rms?
Is there a way to skip a full-blown NPV analysis?
Yes, using the prices (NPVs) of comparable rms.
Valuation is relative: the law of one price in action
Comparables are a way to nd similar rms that have
already been priced by the market, and by using that
information reduce the subjectivity in your calculations.
Comparables are a good check for your NPV analysis.
As always, nothing can replace common s
Why using earnings instead of free cash ows? Earnings are more representative of the entire stream of
cash ows than the cash ow of one particular year.
Also, problem of "manna from heaven" of last class.
Assume that earnings et can be used for investment
or distributed as dividends. A fraction is reinvested.
Let the return on capital (equity) be dened as:
et+1
ROEt+1 =
Kt
Assume that this return is also expected to be a constant in time equal to ROE (w
2
The P/E ratio
2.1
Main formula
Remember the Gordon dividend-growth model?
D
pt =
rg
D is the dividend expected tomorrow t + 1, r is the
relevant cost of capital (e.g., CAPM formula), and
g is the growth rate of dividends. Both r and g are
constant in
Please Value the Following Firms
14-1
100
Attribute Known.
(Hopefully Correct!
Similar Firms Available.
Value
80
60
=> High Accuracy in Pricing.
40
?
20
0
0
20
40
60
80
100
80
100
80
100
80
100
Relevant Value Attribute(s)
100
Value
80
Good proxy for relev
2.2
Present value of growth opportunities
(PVGO)
faster growing companies have higher P/E ratios.
How much exactly of the value of a rm can be
attributed to growth?
A rm with constant earnings distributed as dividends ( = 0) is like a perpetuity:
e
pno
If ROE < r investors are better o receiving earnings as dividends instead of reinvesting in that rm
(their opportunity cost is higher than what this project
yields)
We can write the P/E ratio as:
p
1 P V GO
= +
e
r
e
Growth opportunities can be a big c