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Valuation ratios

Analyzing Valuation and Capital Market Ratios:


Price-earning (P/E), Price to book value (P/B), DPS,
Dividend Yield, Retention, and Pay-out.

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1: Price Earnings Ratio (P/E Ratio)


2

PE = Market Price per Share / Earnings per Share


There are a number of variants on the basic PE ratio in use.
1. Price is usually the current price (though some like to use
average price over last 6 months or year).
2. EPS in most recent financial year (current), EPS in most
recent four quarters (trailing), EPS expected in next fiscal year
or next four quartes (both called forward).
Primary, diluted or partially diluted
Before or after extraordinary items

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Implication
3

Business news papers regularly publish the P/E


ratios. They use historical profits to calculate the
ratio.
Analysts use forecast EPS to calculate the P/E ratio.
Use of forecast profits is consistent with the
fundamental valuation principle, which says that the
value of the company equals the discounted free
cash flow that the company is expected to generate
in future.
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Implication
4

EPS is affected by the capital structure. Therefore the


P/E ratio is also affected by capital structure.
When the unlevered P/E ratio equals the reciprocal of
the cost of debt, the leverage has no effect on the P/E.
P/E ratios of companies having different capital
structures are not comparable.
Note: EV/EBIT ratio is not affected by the capital
structure. Therefore it is comparable across companies.
Analysts prefer to use EV/EBIT instead of P/E
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P/E Ratio and Fundamentals


5

To understand the fundamentals, start with a stable


growth dividend discount model:
D1
P0
Ke g
P0 (1 b) (1 g ) ( Payout ) (1 g )

E0
Ke g
Ke g

Note:

Growth rate (g) = b ROE


b is the retention rate and ROE is the return on equity.
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Implication
6

Other things held equal :


1.
Higher growth firms will have higher PE ratios than lower
growth firms.
2.
Higher risk firms will have lower PE ratios than lower risk
firms
3.
Firms with lower reinvestment needs will have higher PE
ratios than firms with higher reinvestment rates.
Note: Of course, other things are difficult to hold equal since
high growth firms, tend to have risk and high reinvestment rats.
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Supernormal growth firm


7

P/E ratio for a high growth firm can also be related


to fundamentals. In the special case of the twostage dividend discount model, this relationship can
be made explicit fairly simple:

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Where,
8

growth rate.

indicates supernormal growth rate and


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gn

indicate normal

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Implication
9

1.

2.

3.

In this model, the PE ratio for a high growth firm is


a function of growth, risk and payout, exactly the
same variables that it was a function of for the
stable growth firm.
The only difference is that these inputs have to be
estimated for two phases - the high growth phase
and the stable growth phase.
Expanding to more than two phases, say the three
stage model, will mean that risk, growth and cash
flow patterns in each stage.
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Earnings-price (E/P) ratio


and the cost of equity
10

As a general rule, it is not theoretically correct to


use E/P as a measure of equity. Alternatively, E/P
ratio does not reflect the true expectations of the
ordinary shareholders.
Example: current market price per share is Rs.500
(FV=100) and EPS =Rs. 10.
E/P ratio= 10/500= 0.02= 2%
Hence expectation of investors is 2%. Is it true?
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Refer Note: A

Implication
11

Consider the following situations:


1.
2.

No-growth firms
Expansion rather than growth faced by the firm.

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P/E ratio and capital structure


12

As EPS is affected by capital structure, therefore


P/E ratio is also affected by capital structure.
Hence P/E ratios of companies having different
capital structures are not comparable.
Enterprise value to EBIT ratio is not affected by
the capital structure. Therefore it is comparable
across companies. Analysts prefer to use EV/EBIT
ratio instead of P/E ratio.
V

NOPLAT (1 g / ROIC )
WACC g
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Refer note B & B-

Implication
13

On resolving the above equation for


no growth firm (g = 0):V
(1 T )

EBIT
WACC
1
V

EBIT (1 T )
WACC

If we consider no debt in the capital structure of the company : P/E


= 1/ke, indicating P/E and cost of equity are moving in opposite
direction, i.e. high P/E ratio implies low cost of equity.
In other words, high P/E ratio of a no growth company implies
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that the capital market perceives low risk in equity investments.

Analysts point
14

Higher EV to EBIT ratio, which is similar to P/E ratio,


implies that the market expects high growth rate
and or high ROIC for the company. WACC differs
among industries .
Hence, EV/EBIT ratio of companies operating in
different industries are not comparable.

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Some Implication
15

1.

2.

3.

The P/E ratio is a widely used tool for valuation of


common stock. One of its prime virtues is its simplicity of
calculation. In fact, there are times a more complex
calculation analogous to a P/E ratio gives more useful
information.
When a firm has an abnormal liability or an abnormal
amount of cash available for distribution, and in analogous
situations, adjustments to the P/E calculations of the type
illustrated give measures that better reflect the special
circumstances.
If it is necessary to adjust the value equation of a stock for
complexities, it is also necessary to consider adjusting the
target or the observed price-earnings ratio for that stock.
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a. Adjustment of extraordinary liability


16

The P/E ratio (P/E = (1-b)/ke-g) does not explicitly include an adjustment for any balance
sheet measure. Assume that a firm has an extraordinary liability. The liability might be for
such items as:
Damages (e.g. , faulty automobile tires, Pharmaceuticals that were harmful).
Unfunded contractual pension liabilities.
Unfunded contractual medical benefit liabilities.
The liabilities associated with buying another firm.

Assume the earnings of the latest year do not reflect any of these liabilities. A low P/E
might not represent an investment opportunity, but rather large expected liability
payments.

Refer note C

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Implication
17

Now assume a special (an addition to the normal


liability) forecasted liability of L, and that the stock
value using the conventional cash flow or dividend
model (not considering L) is reduced by L:

P0 L (1 b) (1 g )

E0
Ke g

In a sense, the investor buying the dividend stream


inherits the obligation to pay off the liability, and
thus we can view the price as
higher by L.
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Analysts point
18

The relevant ratio for many purposes of valuation is


(P+L)/E , rather than P/E.
The extraordinary liability (an expectation) must be
considered while evaluating P/E.
Example: Expected EPS = 5.10 , current selling price of
the share = Rs.18.
Hence P/E = 18/5.10 = 3.5
If the expected liability (extra-ordinary incremental
liability) of 1.1bn or Rs.20.30 per share.
Adjusted P/E = (18+20.30)/5.1
= 7.51
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Implication
19

Thus an analyst should adjust a very attractive


P/E ratio (to an investor) upward to a less
attractive level by adding the liability to the stock
price.

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b. Adjustment of Excess Asset


20

AN EXCESS ASSET
Assume a firm can divert assets that it owns without
adversely affecting its future cash flow stream. The most
easily identified asset of this nature is excess cash (cash
that is not an essential component of working capital). If
the analyst computes the value of the firm using a cash flow
model, it is now necessary to add the value of the excess
cash to the present value of the cash flows (if it is not
already included).
In like manner, if the P/E calculation does not reflect this
extra asset, it should be adjusted. The excess asset
adjustment is analogous to the adjustment for an
extraordinary liability, but the effect is exactly opposite.
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Excess Cash Balance


21

Excess cash and marketable securities do not contribute to the


operations of the company. Therefore , it is appropriate to exclude
excess cash and marketable securities from invested capital (for
computing ROIC/ROA/ROCE).
Companies do not disclose the amount of excess cash and
marketable securities.
An analyst usually estimates the excess cash and marketable
securities by comparing actual cash balance with the industry
average. Some analysts compare actual balance with average of
similar companies.
Refer- comparison.
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Excess asset adjustment


22

D1
SD
P
Ke g
P SD
(1 b)

E
Ke g
SD = Special Distribution on account of excess
asset (Cash Balances)
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An Example
23

Ford Motor Co. as of April 2000 had a cash


balance in excess of $24 billion. Assume that $10
billion or $8.11 per share (with 1.233 billion fully
diluted shares) is available for distribution. The
stock price P reflects the present value of normal
dividends plus the $8.11 per share special
distribution (SD) that the firm can pay. The current
market price for the share = $51.25 and EPS
estimate for the year 2000 is $6.05
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Implication
24

At first glance, the PE ratio is an awkward number.


The numerator is a market based trading price
which is long term and forward looking in nature
while the denominator is often a historical
accounting number collected for one financial year.
It seems reasonable to expect this combination to
be rather meaningless. Yet, the ratio remains one of
the most popular techniques for valuation, and
investors keep relying on this seemingly futile
measure.
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Analysts point
25

P/E ratio reflects investors expectation about the


growth in the firms earnings. Industries differ in their
growth prospects, accordingly the P/E ratios for
industries vary widely.

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Some Indian Example: Peer set IT


Fact Sheet >>
Peerset
Name

NOC Full Year (Rs Cr.)


Year End Equity Gr. Blk Sales
NP
NP Var%
Composite
12
2,040.26 39,973.86 156,361.45 33,057.88
Cognizant Tech
201103
4 3,376.21 9,119.07 2,196.19 64
HCL Technologies
201206 138.72 2,880.57 8,907.22 1,950.42 63
IBM India
201103 230.36 4,203.01 15,413.30 1,291.00 102
Infosys
201203 287.12 7,173.00 31,254.00 7,986.00 24
MphasiS
201110 210.14
710.87 3,404.13
780.71 -22
Oracle Fin.Serv.
201203
41.99
637.19 2,605.85
922.4
-6
Patni Computer
201112
27.17 1,176.09 2,151.67
471.82 -26
Polaris Finan.
201203
49.72
184.2 1,757.47
183.41
-2
Satyam Computer
201203 235.37 2,146.00 5,964.30 1,130.34 169
TCS
201203 195.72 7,282.02 38,858.54 10,965.88 46
Tech Mahindra
201203 127.61 1,396.90 5,243.00 508.34 -27
Wipro
201203 492.34 8,807.80 31,682.90 4,671.37
-3
27

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P/C

0
17.3
0
17.2
9.8
25.8
12
5.5
9.1
24.9
16.7
18.1

P/E
18.50
0
20.4
0
19
11.1
27
14.9
6.7
10.3
26.7
21.8
21.1

P/BV

0
6.03
0
4.82
2.48
3.98
2.07
1.12
3.51
10.93
3.16
3.85

2: Price-earning to earning Growth


(PEG)
28

The PEG ratio is the ratio of price earnings to expected growth in earnings
per share.
PEG = PE / Expected Growth Rate in Earnings
Definitional tests:
Is the growth rate used to compute the PEG ratio
on the same base? (base year EPS)
over the same period?(2 years, 5 years)
from the same source? (analyst projections, consensus estimates..)
Is the earnings used to compute the PE ratio consistent with the growth
rate estimate?
No double counting: If the estimate of growth in earnings per share is
from the current year, it would be a mistake to use forward EPS in
computing PE.
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Interpretation
30

PEG Ratio: Reading the Numbers:


The average PEG ratio for the beverage sector is
2.00. The lowest PEG ratio in the group belongs to
Hansen Natural, which has a PEG ratio of 0.57.
Using this measure of value, Hansen Natural is
the

most under valued stock in the group


the most over valued stock in the group
What other explanation could there be for Hansens low
PEG ratio?

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Empirical evidence
31

Lynch (1990) recommends comparing the growth rate to


the price-earnings (PE) ratio as a screening device.
Gardener and Gardener (2001) recommend the PEG ratio
as a way to determine whether PE is too high or too low.
A recent survey of valuation practices found that 22 of
43 investment professionals used the PEG ratio as part of
their arsenal of valuation techniques (see Dukes, Peng,
and English [2006]), and Peters [1991) suggests that
PEG is a useful approach for portfolio managers.
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Implication
32

Nearly all proponents of using the PEG ratio in investment


analysis suggest that the short-term growth rate should
approximate the PE ratio when firms are correctly valued,
suggesting that a benchmark PEG of 1.0 is appropriate for stock
screening and identifying potential investments.
For example: Lynch (1990, p.l98) claims that stocks with PEG
below 0.5 are most likely undervalued, and stocks with PEG
above 2.0 are most likely overvalued, while Gardener and
Gardener (2001) indicate that "a PEG of 1 would indicate full
valuation."'

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PEG Ratios and Fundamentals:


34

1. High risk companies will trade at much lower PEG ratios than low risk
companies with the same expected growth rate.
The company that looks most under valued on a PEG ratio
basis in a sector may be the riskiest firm in the sector

2: Companies that can attain growth more efficiently by investing less in


better return projects will have higher PEG ratios than companies that grow
at the same rate less efficiently.
Companies that look cheap on a PEG ratio basis may be
companies with high reinvestment rates and poor project
returns.
3: Companies with very low or very high growth rates will tend to have
higher PEG ratios than firms with average growth rates. This bias is worse for
low growth stocks.
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PEG ratios do not neutralize
the growth
effect.

A Variant on PEG Ratio: The PEGY ratio


35

The PEG ratio is biased against low growth firms


because the relationship between value and growth is
non-linear.
One variant that has been devised to consolidate the
growth rate and the expected dividend yield:
PEGY = PE / (Expected Growth Rate + Dividend Yield)
As an example: ABC Co. has a PE ratio of 16, an
expected growth rate of 5% in earnings and a
dividend yield of 4.5%.
PEG = 16/ 5 = 3.2
PEGY = 16/(5+4.5) = 1.7

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3: Price to Book value Ratio


36

A.

The price/book value ratio is the ratio of the market value


of equity to the book value of equity, i.e., the measure of
shareholders equity in the balance sheet.
Price/Book Value = Market Value of Equity/Book Value of Equity

Consistency Tests:
A.
If the market value of equity refers to the market value of
equity of common stock outstanding, the book value of
common equity should be used in the denominator.
B.
If there is more that one class of common stock outstanding,
the market values of all classes (even the non-traded
classes) needs to be factored in.
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Price Book Value Ratio


37

Case of stable growth firm:


P0

BV0 ROE (1 b) (1 g )
D1

Ke g
Ke g

P0
ROE (1 b) (1 g )

BV0
Ke g
If the return on equity is based upon expected earnings
in the next time period, this can be simplified to,

P0
ROE (1 b)

BV0
Ke g

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An Implication
38

The price-book value ratio of a stable firm is


determined by return on equity and the required rate
of return on its projects.
Given the relationship between price-book value ratios
and returns on equity, it is not surprising to see firms
which have high returns on equity selling for well above
book value and firms which have low returns on equity
selling at or below book value.
The firms which should draw attention from investors are
those which provide mismatches of price-book value
ratios and returns on equity - low P/BV ratios and high
ROE or high P/BV ratios and low ROE.
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Source: damodaran online

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The P/B-ROE Relationship


40

(
P
/
B
)
B

B K gB K gB
Refer Note: E
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Current period P/B & P/E Relationship


41

P
P
E

B
E
B
P
P

ROE
B
E

Price to book value is a function of priceearning and ROE of the firm.


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Implication
42

High P/B

High performing companies


High P/E
Expected positive RI
Increasing income

Declining companies
Low P/E

Expected positive RI
Decreasing income

Low P/B

Improving companies
Expected negative RI
Increasing income

Poor performing companies


Expected negative RI
Decreasing income
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Empirical evidence
43

Shareholder Value and the Articulation of P/B


and Stock Return in Egypts CASE50 Index
By: Tarek Ibrahim Eldomiaty & Hany Kamel
International Research Journal of Finance and
Economics ISSN 1450-2887 Issue 23 (2009)
EuroJournals Publishing, Inc. 2009
http://www.eurojournals.com/finance.htm

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Refer:
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Research paper

Analyst point
44

1.

2.

3.

The paper presents a proof that the P/B ratio (being


a proxy for shareholder value) takes into account the
stock returns as well. This renders the P/B ratio very
good proxy for the measurement of shareholder
value.
H1: A negative relationship exists between the firms
P/B ratio and each of liquidity, expense control,
leverage and dividend payout ratio.
H2: A positive relationship exists between the firms P/B
ratio and each of asset efficiency, profitability and
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dividend yield