Stock Valuation

Earnings Multiplier Model

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Price Earning Ratio

If we divide both sides of the equation by E1 (expected earnings during the next
12 months), the result is

Thus, the P/E ratio is determined by

1. The expected dividend payout ratio (dividends divided by earnings)
2. The estimated required rate of return on the stock (k)
3. The expected growth rate of dividends for the stock (g)
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Consider the following estimates for an example firm:

D/E = 0.50
k = 0.12
g = 0.09
E0 = $2.00

P/E =

P/E =

P/E = 16.7
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Given current earnings (E0) of $2.00 and a g of 9 percent, we would expect E1

to be $2.18.

Therefore, we would estimate the value (price) of the stock as

V = 16.7 × $2.18
= $36.41
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You have been reading about the Maddy Computer Company (MCC),
which currently retains 90 percent of its earnings ($5 a share this year). It
earns an ROE of almost 30 percent. assuming a required rate of return of
14 percent, how much would you pay for MCC on the basis of the earnings
multiplier model? Discuss your answer. What would you pay for Maddy
Computer if its retention rate was 60 percent and its ROE was 19 percent?
Show your work.
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Required rate of return (k) 14%
Return on equity (ROE) 30%
Retention rate (RR) 90%
Earnings per share (EPS) $5.00

Then growth rate = Retention Rate x ROE

= 0 .90 x 0.30 = .27

Since the required rate of return (k) is less than the growth rate (g), the earnings
multiplier cannot be used (the answer is meaningless).
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However, if ROE = .19 and RR = .60,

then growth rate = .60 x .19 = .114

If next year’s earnings are expected to be: $5.57 = $5.00 x (1 + .114)

Applying the P/E: Price = (15.38) x ($5.57) = $85.69

Thus, you would be willing to pay up to $85.69 for Maddy Computer
Company stock.
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The Shamrock Dogfood Company (SDC) has consistently paid out 40
percent of its earnings in dividends. The company’s return on equity is 16
percent.

What would you estimate as its dividend growth rate?

Given the low risk in dog food, your required rate of return on SDC is 13
percent. What P/E ratio would you apply to the firm’s earnings?

What P/E ratio would you apply if you learned that SDC had decided to
increase its payout to 50 percent?
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Dividend payout ratio 40%

Return on equity 16%

Growth rate = (Retention rate) x (Return on equity)

= (1 - payout ratio) x (Return on equity)
= (1 - .40) x (.16)
= .60 x .16
= 9.6%
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Dividend payout ratio 40%
Dividend growth rate 9.6%
Required rate of return 13%
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Dividend payout ratio 50%

Required rate of return 13%

Growth rate = (1 - .50) x (.16)

(new) = .50 x .16
= .08
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. Given Hitech’s beta of 1.75 and a risk-free rate of 7 percent, what is the
expected rate of return assuming
a. a 15 percent market return?
b. a 10 percent market return?
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(a). RH = .07 + 1.75(.15 - .07) = .07 + .14 = .21 or 21%

(b). RH = .07 + 1.75(.10 - .07) = .07 + .0525 = .1225 or 12.25%

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Christie Johnson, CFA, has been assigned by Carroll to analyze Sundanci
using the constant-growth dividend price/earnings (P/E) ratio model.
Johnson assumes that Sundanci’s earnings and dividends will grow at a
constant rate of 13 percent.
The Net Income and Dividend for the company are as follows:
1999 2000
Net Income 60 80
Dividend 18 24
The required rate of Return for the company is 14%

Calculate the P/E ratio on Johnson’s assumptions for Sundanci.

Show your work.
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P/E

P/E = payout ratio/(r – g)

= 0.30/(0.14 – 0.13)
= 30.0x
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A company that Jones is researching is Mackinac Inc., a U.S.-based
manufacturing company. Mackinac has released its June 2001 financial
statements, indicating the following information

Net Income 37,450

Total Equity 150,000
Dividend Payment 22,470

The required rate of return for the company is 15%. Jones is particularly
interested in Mackinac’s sustainable growth and sources of return.

Calculate Mackinac’s sustainable growth rate and Price Earning Multiplier. Show
your calculations.
.
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(Sustainable growth rate = return on equity x earnings retention rate

= ($37, 450 /$150,000) x (1 – ($22,470/$37,450)

= 24.97% x 0.40
= 9.99%
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Peter Lynch, the former portfolio manager of Fidelity Investments’ highly

successful Magellan Fund, looks for the following attributes when he analyzes
firms.

Favorable Attributes of Firms The following attributes of firms may result in

favorable stock market performance:

●The firm’s product is not faddish; it is one that consumers will continue to
purchase over time.

2. The company should have some long-run comparative competitive

advantage over its rivals that is sustainable.
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3. The firm’s industry or product has market stability. Therefore, it has little
need to innovate or create product improvements or fear that it may lose a
technological advantage. Market stability means less potential for entry.

4. The firm can benefit from cost reductions. An example would be a

computer manufacturer that uses technology provided by suppliers competing
to deliver a faster and less expensive machine or computer chip.

5. Firms that buy back their shares or companies where management is

buying shares, which indicates that its insiders are putting their money into
the firm.
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The following tenets are from Hagstrom’s The Essential Buffett:

Business Tenets
. Is the business simple and understandable?
(This makes it easier to estimate future cash flows with a high degree of
confidence.)
. Does the business have a consistent operating history?
(Again, cash flow estimates can be made with more confidence.)
. Does the business have favorable long-term prospects?
(Does the business have a “franchise”—meaning a product or service that is
needed or desired without a close substitute and is not regulated? This implies
the firm should have
pricing flexibility.)
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Management Tenets
. Is management rational?
(Is the allocation of capital to projects that provide returns above the cost of
capital? If not, do they pay capital to stockholders through dividends or
repurchase stock?)
. Is management candid with its shareholders?
(Does management tell owners everything you would want to know?)
. Does management resist the institutional imperative?
(Does management not attempt to imitate the behavior of other managers?)
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Financial Tenets
. Focus on return on equity, not earnings per share.
(Look for strong ROE with little or no debt.)
. Calculate “owner earnings.”
(“Owner earnings” are basically equal to “free cash flow” after capital
expenditures.)
. Look for a company with relatively high profit margins for its industry.
. Make sure the company has created at least one dollar of market value for
every dollar retained.
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Market Tenets
. What is the value of the business?
(Value is equal to future free cash flows discounted at a government bond rate.
Using this low rate is considered appropriate because the business owner is
very confident of his/her cash flow estimates due to extensive analysis, and this
confidence implies low risk.)
. Can the business be purchased at a significant discount to its fundamental
intrinsic value?
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Growth companies as those that consistently experience above-average increases
in sales and earnings.

Growth company as a company with the management ability and the opportunities to
make investments that yield rates of return greater than the company’s required rate
of return.

This required rate of return is the company’s weighted average cost of capital.

A growth stock is a stock with a higher rate of return than other stocks in the market
with similar risk characteristics. The stock achieves this superior risk-adjusted rate of
return because at some point in time the market undervalued it compared to other
stocks.
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Defensive companies are those whose future earnings are likely to withstand
an economic downturn. One would expect them to have relatively low business
risk and not excessive financial risk. Typical examples are public utilities or
grocery chains—firms that supply basic consumer necessities.
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First, a defensive stock’s rate of return is not expected to decline during an

overall market decline, or decline less than the overall market.

Second, our CAPM discussion indicated that an asset’s relevant risk is its
covariance with the market portfolio of risky assets—that is, an asset’s
systematic risk. A stock with low or negative systematic risk (a small positive or
negative beta) may be considered a defensive stock according to this theory
because its returns are unlikely to be harmed significantly in a bear market.
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A cyclical company’s sales and earnings will be heavily influenced by

aggregate business activity.
Examples would be firms in the steel, auto, or heavy machinery industries.
Such companies will do well during economic expansions and poorly during
economic contractions. This volatile earnings pattern is typically a function of
the firm’s business risk (both sales volatility and operating leverage) and can
be compounded by financial risk.
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A cyclical stock will experience changes in its rates of return greater than
changes in overall market rates of return. In terms of the CAPM, these would
be stocks that have high betas. A cyclical stock is the stock of any company
that has returns that are more volatile than the overall market—that is, high-
beta stocks that have high correlation with the aggregate market and greater
volatility.
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A speculative company is one whose assets involve great risk but that also has a
possibility of great gain. A good example of a speculative firm is one involved in oil
exploration.

A speculative stock possesses a high probability of low or negative rates of return

and a low probability of normal or high rates of return. Specifically, a speculative
stock is one that is overpriced, leading to a high probability that during the future
period when the market adjusts the stock price to its true value, it will experience
either low or possibly negative rates of return. Such an expectation might be the
case for an excellent growth company whose stock is selling at an extremely high
price/earnings ratio—i.e., it is substantially overvalued.
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Value stocks are those that appear to be undervalued for reasons other than
earnings growth potential. Value stocks are usually identified by analysts as
having low price-earning or price-book value ratios.
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Price/Book Value (P/BV) is used as a measure of relative value because, in

theory, market price (P) should reflect book value (BV). In practice, the two
can differ dramatically. Some researchers have suggested that firms with low
P/BV ratios tend to outperform those with high P/BV ratios.

A high P/BV ratio such as 3.0 can result from a large amount of fixed assets
being carried at historical cost. A low ratio, such as 0.6, can occur when assets
are worth less than book value, for instance, bad real estate loans by banks.
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The price/cash flow ratio (P/CF) has become more popular because of the
increased emphasis on cash by various analysts and because of the increased
availability of cash flow numbers. Differences could result from differences in net
income or non-cash items.
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Price/sales ratio varies dramatically by industry. For example, the sales per
share for retail firms are typically higher than sales per share for technology
firms. The reason for this difference is related to the second consideration, the
profit margin on sales. The retail firms have high sales per share, which will
cause a low P/S ratio, which is considered good until one realizes that these
firms have low net profit margins.
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A biotechnology firm is growing at a compound rate of over 21 percent a year.

(Its ROE is over 30 percent, and it retains about 70 percent of its earnings.)
The stock of this company is priced at
about 65 times next year’s earnings. Discuss whether you consider this a
growth company and/or a growth stock.
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The biotechnology firm may be considered a growth company because (1) it

has a growth rate of 21 percent per year which probably exceeds the growth
rate of the overall economy, (2) it has a very high return on equity and (3) it
has a relatively high retention rate. However, since a biotechnology firm
relies heavily on continuous research and development, the above-average
risk will require a high rate of return. Therefore, it is unlikely that the stock
would be considered a growth stock due to the extremely high price of the
stock relative to its earnings.
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You are told that a growth company has a P/E ratio of 13 times and a growth
rate of 15 percent compared to the aggregate market, which has a growth
rate of 8 percent and a P/E ratio of 16 times. What does this comparison
imply regarding the growth company? What else do you need to know to
properly compare the growth company to the aggregate market?
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The projected growth rate for the company (15%) is above that of the market
(8%); however, the growth company also has a lower P/E ratio than the
aggregate market. This implies that the stock of the growth company might
be undervalued. It would be necessary to investigate the company further to
determine if the firm’s stock is a growth stock. It is still necessary to estimate
the average payout ratio and the ROE and its components for both the firm
and the aggregate market in order to make a proper comparison of the
growth company to the aggregate market. This should help you determine if
it is currently a true growth company and if this performance can be
sustained