FE 445 – Investment Analysis and Portfolio

Management
Fall 2020

Farzad Saidi

Boston University | Questrom School of Business

Chapter 15: Price-to-earnings
(P/E) ratios
Determining “g”

The dividend discount model is sensitive to the choice of g .

What determines g ?

• With zero net investment (gross investment = depreciation), we just

maintain the value of assets
• Growth generally requires positive net investment
• The rate of growth will depend on both:
1. the amount of investment and
2. the return on that investment
• All else equal, firms will grow faster if they invest more and if they
earn a higher rate of return on their investments

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Growth opportunities

Companies choose growth rate in dividends g :

g = b × ROE ,

where

• Return on equity: ROE = Net earnings) / Book value

• b = plowback or retention percentage rate, percentage of earnings
reinvested in the firm

Derivation:

earnings next year = earnings this year + net investment × ROI

= earnings this year + retained earnings × ROE
 
earnings next year retained earnings
−1= × ROE
earnings this year earnings

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Example: JPMorgan Chase in November 2005

• Commercial and investment banking. Has grown through

acquisitions, some of which it has problems digesting. In the most
recent fiscal year:
• DPS of $1.36 with an EPS of $2.08, payout ratio of ≈ 65.38%, ROE
of 11.16%
• The estimated cost of equity (CAPM beta ≈ 0.8) was 7.7%
• Assuming it is stable, estimate expected growth rate in EPS:

g = b × ROE = (1 − 0.6538) × 11.16% = 3.86%

• Price per share

= Expected dividend next yr/(Cost of equity − Expected growth rate)

= $1.36 × 1.0386/(0.077 − 0.0386) = $36.78

• Actual stock price (early November 2005) = $38

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Example

• Value two firms with 100% dividend payout: b = 0, thus g = 0

• Both have: E1 = $5, D1 = $5, k = 12.5%
• Cash Cow, Inc. (CC) has ROE = 12.5%
• Growth Prospects (GP) has ROE = 15%
• Should either or both firms retain some earnings?

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Example (ctd.)

Value the same two firms with 40% dividend payout:

• Remember: E1 = $5 and k = 12.5%

• Cash Cow, Inc. (CC) has ROE = 12.5%
• b = . . . . . . . . . thus g = . . . . . . . . .
• D1 = . . . . . . . . . and V (CC ) = . . . . . . . . .
• Growth Prospects (GP) has ROE = 15%
• b = . . . . . . . . . thus g = . . . . . . . . .
• D1 = . . . . . . . . . and V (GP) = . . . . . . . . .
• Which has increased in value more? Why?

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Value of growth opportunities

• Compare ROE to that available in the market (k) for same b

• If ROE > k, the company should retain earnings to grow
• If ROE = k, the company has reached its optimal size
• If ROE < k, the company is too big or inefficient
• Present value of growth opportunities:

PVGO(g ) = Value with growth g − Value without growth

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Two reinvestment policies

When ROE > k, giving up dividends now leads to substantially higher

dividends later ⇒ higher value

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Payout ratios

return on assets payout ratio growth rate

Computer Software
Adobe Systems 15.5% 0.0% 14.1%
Cogizant 19.0% 0.0% 20.8%
Compuware 17.0% 0.0% 13.5%
Inuit 20.5% 0.0% 11.0%
Microsoft 34.5% 26.0% 14.8%
Oracle 32.0% 0.0% 14.5%
Red Hat 11.5% 0.0% 31.0%
Parametric Tech 14.5% 0.0% 15.1%
SAP 22.5% 32.0% 13.6%

Median: 19.0% 0.0% 14.5%

Electric Utilities
Central Hudson G&E 5.0% 78.0% 3.2%
Central Vermont 5.0% 56.0% 1.0%
Consolidated Edison 5.5% 74.0% 1.6%
Duke Energy 5.5% 73.0% 3.7%
Northeast Utilities 5.5% 48.0% 5.8%
Nstar 9.0% 61.0% 7.7%
Pennsylvania Power 12.5% 50.0% 37.0%
Public Services Enterprise 11.5% 43.0% 6.0%
United Illuminating 7.0% 82.0% 2.5%

Median: 5.5% 61.0% 3.7%

⇒ Firms with growth prospects indeed pay out less!

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P/D and P/E ratios

• P/D ratio: inverse of dividend yield

D1 P0 1
P0 = V0 = ⇒ =
k −g D1 k −g

• P/E ratio: (used more in practice)

D1 P0 1−b
P0 = V0 = ⇒ =
k −g E1 k −g

• Remember: g = ROE × b and D = E × (1 − b)

• Riskier stock ⇒ higher k ⇒ lower P/E
• Growth stock ⇒ higher g ⇒ higher P/E
• PEG ratio: P/E to g, low PEG could be a bargain

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Problem

• Calculate the P/E ratio of Growth Prospects (GP)

• Remember: ROE = 15%, E1 = $5, k = 12.5%
• Without reinvestment (b = 0):
• g = .........
• P/E = . . . . . . . . .
• With reinvestment of b = 0.6
• g = .........
• P/E = . . . . . . . . .
• Did the P/E increase? Why?

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Plowback ratio and P/E

Plowback ratio (b)

0 0.25 0.5 0.75
ROE Growth rate g
10% 0.0% 2.5% 5.0% 7.5%
12% 0.0% 3.0% 6.0% 9.0%
14% 0.0% 3.5% 7.0% 10.5%
ROE P/E ratio
10% 8.33% 7.89% 7.14% 5.56%
12% 8.33% 8.33% 8.33% 8.33%
14% 8.33% 8.82% 10.00% 16.67%

High growth not necessarily good: only if ROE > k

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Industry P/E ratios

Industries with less growth opportunities have lower P/E

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Potential issues

Using P/E ratios is relative valuation:

• High P/E stock not necessarily overvalued

What if earnings are negative or unreliable?

• Negative earnings: start-ups or firms being restructured

• Earnings might be manipulated
• Earnings higher if inflation is high
• Use other ratios:
• Price-to-book
• Price-to-sales
• Use cash flow instead of earnings

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Company valuations (03/28/2018)

Apple Tesla Goldman Lululemon

Market Cap (equity only) 848.53B 43.31B 93.06B 11.77B
Enterprise Value (incl. debtholders) 921.88B 61.21B -210.9B 10.38B
Trailing P/E 17.24 N/A 27.56 43.18
Forward P/E 12.76 109.57 10.38 28.78
PEG Ratio (5 yr expected) 1.26 -1.39 0.51 2.06
Price/Sales (ttm) 3.55 3.68 2.9 4.69
Price/Book (mrq) 6.06 10.21 1.37 8.28

Source: http://finance.yahoo.com

• mrq = Most Recent Quarter

• ttm = Trailing Twelve Months
• yoy = Year Over Year
• lfy = Last Fiscal Year
• fye = Fiscal Year Ending

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Aggregate P/E ratio for S&P500

45 16
P/E
40 10y yield 14

35
12

30
10
P/E Ratio

10y yield
25
8
20

6
15

4
10

5 2

0 0

1880 1900 1920 1940 1960 1980 2000 2020

Source: http://www.econ.yale.edu/∼shiller/data.htm

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Aggregate real earnings for S&P500

120 3000
earnings
S&P500

100 2500

80 2000
real earnings

S&P500
60 1500

40 1000

20 500

0 0

1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020

Source: http://www.econ.yale.edu/∼shiller/data.htm

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Time-varying aggregate P/E ratios

Potential causes of time-variation in P/E ratios:

• In bubbles P/E too high

• Time-varying risk aversion
• If E (rM ) − rf increases in crisis since σM increases:
⇒ k increases for all stocks
⇒ lower aggregate P/E ratios
• Investors are more risk averse in downturns
• More “risk appetite” in booms: lower required E (rM ) − rf

P0 1−b
=
E1 k −g

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Valuation based on comparable firms

Another application of the valuation principle is the method of

comparables (or “comps”)

• Valuation principle: two securities with identical cash flows must

have the same price
• Estimate the value of the firm based on the value of other,
comparable firms or investments that we expect will generate very
similar cash flows in the future
• Of course, identical companies do not really exist
• We can adjust for scale differences using valuation multiples

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Valuation multiples

Definition: ratio of a firm’s value to some measure of the firm’s scale or

cash flow

• Price-to-earnings ratio
• Most common valuation multiple
• Usually included in basic statistics computed for a stock
• Share price divided by earnings per share
• Buying a stock is the same as buying the rights to the firm’s future
earnings
• Current EPS × Average P/E of comps
• Problems: What if earnings are negative or unreliable?

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Valuation multiples

• Enterprise-value multiples
• EBIT
• EBITDA
• Free cash flow
• Multiples of sales
• If it is reasonable to assume margins are similar in the future
• Price-to-book value of equity
• Firms with substantial tangible assets
• Industry-specific ratios
• Cable TV: enterprise value per subscriber

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Ratios for the S&P 500

On the aggregate level different ratios look similar

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Summary

This class:

• Price-earnings ratios
• Look at the aggregate stock market

Next class:

• Stock exchanges
• Margin and short-selling

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