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## P/E Ratios: What Are The Implications For Equity And Market Analysis

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**P/E Ratios: What Are The Implications For Equity And Market**Analysis Charles Rayhorn, Ph.D., CFP®**Introduction**• 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**Discounting**• 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**Stock Valuation Models**The Basic Stock Valuation Equation**Stock 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.**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.**Stock 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**P/E**• P/E expected is then**P/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**A 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 flows—a 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 them—one, 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.**What Can we say about the Future P/E**• Evidence of Mean Reversion • So stay tuned**WHAT DO P/E RATIOS SAY ABOUT COMPANIES?—Early Results**• Data was collected from Standard and Poor’s 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 S&P 500. P/CF (CLS)—Price/Cash Flow—Close. • Dividend Yield. . • Relative Dividend Yield. Book Value. • LTD/EQ—Long-Term Debt to Common Equity.**WHAT DO P/E RATIOS SAY ABOUT COMPANIES?—Early Results**• Data was collected from Standard and Poor’s Market Insight for the 10 year period beginning in 1991 for the Dow 30 companies. The ratios selected are: • CURR—Current Ratio. • QUICK—Quick Ratio. • INTCOV—Interest Coverage. • TIE—Times Interest Earned. • SALES Growth • EPS (BASIC)—Growth. • Cash Flow--Growth • Inventory Turnover. • Receivables turnover. • Total Assets Turnover. • Net Profit Margin.**WHAT 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 ratio’s 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.**WHAT DO RATIOS SAY ABOUT COMPANIES?**• ‘Bad’ companies are associated with low P/E’s • ‘Good’ companies are associated with high P/E’s • ‘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 fundamental—P/E approach seems valid.**Conclusion**• 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**Other Approaches to Stock Valuation**Book Value • Book value per share is the amount per share that would be received if all the firm’s 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 firm’s earnings potential and lacks any true relationship to the firm’s value in the marketplace.**Other 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 firm’s 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 firm’s assets. • However, it still fails to consider the earning power of those assets.**Stock 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 firm’s free cash flows rather than dividends.**Stock 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 firm’s debt and preferred stock must be subtracted from the value of the company to estimate the value of equity.**Stock Valuation Models**Free Cash Flow Model Dewhurst Inc. wishes to value its stock using the free cash flow model. To apply the model, the firm’s CFO developed the data given in Table 7.3.**Stock 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.**Stock 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.**Stock Valuation Models**Free Cash Flow Model**Stock 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