(previous days closing) price per share TABLE 14.2 Excerpt from the
Wall Street Journal Financials, for May 30, 2002 YTD 52-Week YLD
VOL NET %CHG HI LO STOCK (SYM) DIV % P/E 100s CLOSE
CHG 13.5 31.91 23.55 Cadbury Schweppes (CSG) 0.70g 2.4 21 475
29.20 0.
some combination of the two. We can actually narrow this down a little
further. The highest long-run real growth rate of earnings (at the start of
the Industrial Revolution) was no more than 4% per 14.3 PROBLEMS
WITH PRICE/EARNINGS RATIOS 507 year. Add in
(b) in Figure 14.1 than like graph (a). This should not be too surprising,
either, because Figure 14.2 includes firms from many different
industries. (An airline firm may not have the same relation between its
1-year growth rates and long-run growth rates
this method, firms are effectively weighted by their relative market
valuation. Large firms influence the outcome more than small firms.
This may or may not be desirable. In the example, B would become the
dominant determinant of your comparable valuation
price/earnings or The BV versus MV ratio. Older firms have different
book value biases than young firms, so dont compare one to the other.
price/cash flow ratios: the market-equity-to-book-equity ratio.
Sometimes, the book value is interpreted as an estim
no preferred equity, so we will just use com- 15.3, p. 552 mon equity.
Financial debt is usually defined as the sum of long-term debt ($2,651)
and debt in current liabilities ($354), which adds up to $3,005. Total
liabilities are $4,998 + $2,651 + $3,876
Earnings Yield of the S&P 500 Interpreting (Historical) P/E Ratios for
the S&P 500 Lets apply your insights about P/E ratios to the overall
stock market. We shall use the Use the theory on the S&P 500: S&P 500
as a stand-in. Figure 14.3 graphs the P/E rat
firm? What should investors be afraid of, and how can managers comfort
investors? How do these factors influence the firms cost of capital? .
Chapter 19 describes equity payout strategies: dividends and share
repurchases. Typical questions: Are dividend p
can list on the New York Stock Exchange.) On the same day, Yahoo!
Germany reported that Volkswagen AG had earnings of 3.8 billion euros.
In terms of sales, Volkswagen was most similar to Volvo and Ford. What
would you expect Volkswagen to be worth? What a
relation should be negative. This is exactly what we want to test in the
data. Figure 14.2 shows data as of December 2000. It plots the predicted
now-to-nextyear earnings growth rate against the earnings yield (the
ratio of predicted earnings 504 CHAPTER
relatively mild. A simple sanity condition still applies: A firm with more
debt financing has both a lower price of equity and lower earnings. Both
the numerator and denominator change together. solve now! Q 14.19
When would you use a price/sales ratio? W
nominal earnings growth rates. 3. The expected rate of return: What
would have been a reasonable estimate for the rate of return on the stock
market? When surveyed in late 1999, investors claimed expected rates of
return of 1520% or more. After all, they
Decompose these firms values into their two components: 1. The stable
firm is worth $150 = $15 10% + ? = $150 + ? (14.2) Price = Expected
Earnings Cost of Capital + PVGO To be an equality, the question mark
must stand for $0. The market has priced this fi
earnings growth and price/earnings ratios (and thus the figure) changes
over the business cycle, so you must use an up-to-date version for
todays valuation. priate P/E ratios today. The reason is that during
economic booms, earnings growth is high, and, a
receives randomly timed future payoffs. Nevertheless, even in such
cases, there is usually a link between the value of the firm and the value
of the financial claimso thinking of 544 CHAPTER 15 CORPORATE
CLAIMS Firm Value Bond Value Stock Value $0 $0 $0 $
abbreviated the ratio Expected Earnings Next Year/Price Now as the
earnings yield. Of course, a higher price/earnings ratio implies a lower
earnings/price ratio for firms with positive earnings. Therefore, the first
formula says that if your P/E ratio goe
rounded PVGO/P intentionally rather starkly to remove the illusion of
accuracy. I also made no attempt to adjust for corporate debt ratios,
which will be explained in Section 14.3D. Altria is better known as
Philip Morris. P/E Ratios and Earnings Growth R
whatever you wish, you must own all claims that the firm has issued. It
is not enough for you to own only all stock or even all financial claims.
In the most extreme perspective, you can never fully own any firm,
because Uncle Sam always has some claim to
firms do not have any sales yet, or when all firms standard financials
(earnings, sales, etc.) seem irrelevant to the eventual long-term
profitability of the firm, analysts may use even stranger ratios. Here are
a few: Price/employees ratio: This ratio as
earnings, divided by recent earnings) also proxies well for the eternal
growth rate. Our 1-year proxy is easy to compute (take the forecast of
next years earnings, subtract the most recent earnings, and divide by the
most recent earnings)unlike the eterna
and $500 is financed with equity, then its debt has a cost of capital of
7.5% and the equity has a cost of capital of 12.5%. (The numbers I chose
make sense in a perfect market. The so-called weighted cost of capital
($500/$1,000 . 7.5% + $500/$1,000 . 12
worked very well in predicting a correct market value for PepsiCo. In
Cadbury Schweppess case, Now, assume that you instead owned
Cadbury Schweppes (CSG), that it was not valuation-by-comps against
Coca-Cola does not work well. yet publicly traded, and th
stable over the business cycle. Therefore, to value firms, you must first
work out todays prevailing relation between earnings growth and
earnings yields (the inverse of P/E ratios). This says that you cannot
therefore use Figure 14.2 to estimate a good P
Expected Earnings Cost of Capital + PVGO Specifically, the subtractive
part is PVGO = $50. This firm is not expected to be able to maintain its
business. So, PVGO is aptly named: Firms that are stable have zero
PVGO, firms that are growing have positive P
positive sales, analysts P/S has no negative S (1/X) domain problem. It
may work when P/E fails. (Small sales could still be a problem.) often
resort to a price/sales ratio. Because sales are never negative, it largely
avoids the 1/X domain problem. The i
value a biotech start-up that has no sales or earnings? Q 14.44 What is
the quick ratio? Is a firm more or less precarious if this ratio is high?
Q 14.45 What ingredients are in the DuPont model? What are its
problems? PART V Capital Structure and Payout
idealized perfect market. WHAT YOU WANT TO LEARN IN THIS
PART The goal of this part of the book is to explain how firms finance
projects with debt and equity, and how their mix of funding sources
influences the firms cost of capital. . Chapter 15 describe
would be higher for a firm that pursues a pricing strategy that may be
bad. Rolls-Royce and Ford have Problems with price/sales ratio
comparisons are also common in normal similar valuation ratios based
on P/E. times. Some firms have intrinsically low sal
and focus on the perfect market scenario. In this case, Coca-Cola (KO)
PepsiCo (PEP) Cadbury (CSG) Interest + Earnings, Dec. 01 $4.15 $2.95
$0.88 Capital Market Value, May 02 $142.0 $96.2 $17.1 Unlevered
Computed P/E 34.2 32.6 19.4 Unfortunately, in this