The Price-Earnings Ratio Concept and Valuation
In Chapter 2, we introduced the concept of the price-earnings ratio. The price-earnings ratio represents a multiplier applied to current earnings to determine the value of a share of stock in the market. It is considered a pragmatic, everyday approach to valuation. If a stock has earnings per share of $3 and a price-earnings (P/E) ratio of 15 times, it will carry a market value of $45. Another company with the same earnings but a P/E ratio of 20 times will enjoy a market price of $60.
The price-earnings ratio is influenced by the earnings and sales growth of the firm, the risk (or volatility in performance), the debt-equity structure of the firm, the dividend policy, the quality of management, and a number of other factors. Firms that have bright expectations for the future tend to trade at high P/E ratios while the opposite is true for low P/E firms.
For example, the average P/E for the S&P 500 Index firms was 19 in early 2015, but Facebook traded at a P/E of 72 because its earnings were expected to grow dramatically, and ExxonMobil traded at a P/E of 11 because oil prices had fallen and profits were expected to follow oil prices down over the next year.
P/E ratios can be looked up in Barron’s, at finance.yahoo.com, and a number of other publications and Internet sites. Quotations from Barron’s are presented in Table 10-4. The first column after the company’s name shows the ticker symbol and is followed by volume. The third column indicates the yield (dividends per share divided by stock price). The fourth column is the item of primary interest and it indicates the current price-earnings (P/E) ratio. The remaining columns cover the stock price (last), the weekly price change, and earnings and dividend data.
For IBM, which is highlighted in white in Table 10-4, the P/E ratio is 13, indicating that the company’s stock price of $158.72 represents approximately 13 times earnings of $11.90 for the past 12 months.7 Firms that are operating at a loss (deficit) have the symbol dd in the P/E ratio column.
The dividend valuation approach (based on the present value of dividends) that we have been using throughout the chapter is more theoretically sound than P/E ratios and more likely to be used by sophisticated financial analysts. To some extent, the two concepts of P/E ratios and dividend valuation models can be brought together. A stock that has a high required rate of return (Ke) because it’s risky will generally have a low P/E ratio. Similarly, a stock with a low required rate of return (Ke) because of the predictability of positive future performance will normally have a high P/E ratio. These are generalized relationships. There are, of course, exceptions to every rule.
Table 10-4 Quotations from Barron’s
Source: Barron’s, February 9, 2015, p. M18.
Variable Growth in Dividends
In the discussion of common stock valuation, we have considered procedures for firms that had no growth in dividends and for firms that had a constant growth. Most of the discussion and literature in finance assumes a constant growth dividend model. However, there is also a third case, and that is one of variable growth in dividends. The most common variable growth model is one in which the firm experiences supernormal (very rapid) growth for a number of years and then levels off to more normal, constant growth. The supernormal growth pattern is often experienced by firms in emerging industries, such as in the early days of electronics or microcomputers.
Finance in ACTION Managerial An Important Question—What’s a Small Business Really Worth?
The value of a small, privately held business takes on importance when the business is put up for sale, is part of a divorce settlement, or is being valued for estate purposes at the time of the owner’s death. The same basic principles that establish valuation for Fortune 500 companies apply to small businesses as well. However, there are important added considerations.
One factor is that private businesses often lack liquidity. Unlike a firm trading in the public securities market, there is no ready market for a local clothing goods store, a bowling alley, or even a doctor’s clinic. Therefore, after the standard value has been determined, it is usually reduced for lack of liquidity. Although circumstances vary, the normal reduction is in the 30 percent range. Thus a business that is valued at $100,000 on the basis of earnings or cash flow may be assigned a value of $70,000 for estate valuation purposes.
There are other factors that are important to small business valuation as well. For example, how important was a key person to the operation of a business? If the founder of the business was critical to its functioning, the firm may have little or no value in his or her absence. For example, a bridal consulting shop or a barber shop may have minimal value upon the death of the owner. On the other hand, a furniture company with established brand names or a small TV station with programming under contract may retain most of its value.
Another consideration that is important in valuing a small business is the nature of the company’s earnings. They are often lower than they would be in a publicly traded company. Why? First of all, the owners of many small businesses intermingle personal expenses with business expenses. Thus family cars, health insurance, travel, and so on may be charged as business expenses when, in fact, they have a personal element to them. While the IRS tries to restrict such practices, there are fine lines in distinguishing between personal and business uses. As a general rule, small, private businesses try to report earnings as low as possible to minimize taxes. Contrast this with public companies that report earnings quarterly with the intent of showing ever-growing profitability. For this reason, in valuing a small, privately held company, analysts often rework stated earnings in an attempt to demonstrate earning power that is based on income less necessary expenditures. The restated earnings are usually higher.
After these and many other factors are taken into consideration, the average small, private company normally sells at 5 to 10 times average adjusted earnings for the previous three years. It is also important to identify recent sale prices of comparable companies, and business brokers may be able to supply such information. When establishing final value, many people often look to their CPA or a business consultant to determine the true worth of a firm.
In evaluating a firm with an initial pattern of supernormal growth, we first take the present value of dividends during the exceptional growth period. We then determine the price of the stock at the end of the supernormal growth period by taking the present value of the normal, constant dividends that follow the supernormal growth period. We discount this price to the present and add it to the present value of the supernormal dividends. This gives us the current price of the stock.
A numerical example of a supernormal growth rate evaluation model is presented in Appendix 10A at the end of this chapter.
Finally, in the discussion of common stock valuation models, readers may ask about the valuation of companies that currently pay no dividends. Since virtually all our discussion has been based on values associated with dividends, how can this “no dividend” circumstance be handled? One approach is to assume that even for the firm that pays no current dividends, at some point in the future, stockholders will be rewarded with cash dividends. We then take the present value of their deferred dividends.
A second approach to valuing a firm that pays no cash dividends is to take the present value of earnings per share for a number of periods and add that to the present value of a future anticipated stock price. The discount rate applied to future earnings is generally higher than the discount rate applied to future dividends.
SUMMARY AND REVIEW OF FORMULAS
The primary emphasis in this chapter is on valuation of financial assets: bonds, preferred stock, and common stock. Regardless of the security being analyzed, valuation is normally based on the concept of determining the present value of future cash flows. Thus we draw on many of the time-value-of-money techniques developed in Chapter 9. Inherent in the valuation process is a determination of the rate of return that investors demand. When we have computed this value, we have also identified what it will cost the corporation to raise new capital. Let’s specifically review the valuation techniques associated with bonds, preferred stock, and common stock.