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Ratio analysis

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Price-earning (P/E), Price to book value (P/B), DPS,

Dividend Yield, Retention, and Pay-out.

DISHA/2015

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2

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

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.

DISHA/2015

10/01/2015

Implication

4

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

DISHA/2015

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5

growth dividend discount model:

D1

P0

Ke g

P0 (1 b) (1 g ) ( Payout ) (1 g )

E0

Ke g

Ke g

Note:

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

DISHA/2015

10/01/2015

Implication

6

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.

DISHA/2015

10/01/2015

7

to fundamentals. In the special case of the twostage dividend discount model, this relationship can

be made explicit fairly simple:

DISHA/2015

10/01/2015

Where,

8

growth rate.

DISHA/2015

gn

indicate normal

10/01/2015

Implication

9

1.

2.

3.

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.

DISHA/2015

10/01/2015

and the cost of equity

10

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?

DISHA/2015

10/01/2015

Refer Note: A

Implication

11

1.

2.

No-growth firms

Expansion rather than growth faced by the firm.

DISHA/2015

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12

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

DISHA/2015

10/01/2015

Implication

13

no growth firm (g = 0):V

(1 T )

EBIT

WACC

1

V

EBIT (1 T )

WACC

= 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

DISHA/2015 10/01/2015

that the capital market perceives low risk in equity investments.

Analysts point

14

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.

DISHA/2015

10/01/2015

Some Implication

15

1.

2.

3.

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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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

DISHA/2015

10/01/2015

Implication

17

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

inherits the obligation to pay off the liability, and

thus we can view the price as

higher by L.

DISHA/2015 10/01/2015

Analysts point

18

(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

DISHA/2015

10/01/2015

Implication

19

P/E ratio (to an investor) upward to a less

attractive level by adding the liability to the stock

price.

DISHA/2015

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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.

DISHA/2015

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21

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.

DISHA/2015

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22

D1

SD

P

Ke g

P SD

(1 b)

E

Ke g

SD = Special Distribution on account of excess

asset (Cash Balances)

DISHA/2015

10/01/2015

An Example

23

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

DISHA/2015

10/01/2015

Implication

24

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.

DISHA/2015

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Analysts point

25

growth in the firms earnings. Industries differ in their

growth prospects, accordingly the P/E ratios for

industries vary widely.

DISHA/2015

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26

DISHA/2015

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Fact Sheet >>

Peerset

Name

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

DISHA/2015

10/01/2015

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

(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.

DISHA/2015

10/01/2015

29

DISHA/2015

10/01/2015

Interpretation

30

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

the most over valued stock in the group

What other explanation could there be for Hansens low

PEG ratio?

DISHA/2015

10/01/2015

Empirical evidence

31

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.

DISHA/2015

10/01/2015

Implication

32

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."'

DISHA/2015

10/01/2015

33

DISHA/2015

10/01/2015

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

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.

DISHA/2015

10/01/2015

PEG ratios do not neutralize

the growth

effect.

35

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

DISHA/2015

10/01/2015

36

A.

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.

DISHA/2015

10/01/2015

37

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

DISHA/2015

10/01/2015

An Implication

38

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.

DISHA/2015

10/01/2015

DISHA/2015

39

10/01/2015

40

(

P

/

B

)

B

B K gB K gB

Refer Note: E

DISHA/2015

10/01/2015

41

P

P

E

B

E

B

P

P

ROE

B

E

DISHA/2015

10/01/2015

Implication

42

High P/B

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

Expected negative RI

Decreasing income

DISHA/2015

10/01/2015

Empirical evidence

43

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

DISHA/2015

Refer:

10/01/2015

Research paper

Analyst point

44

1.

2.

3.

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

DISHA/2015 10/01/2015

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