Valuation of Corporation

P/E Ratio or earning multiples Model of valuation

Earnings Multiple Approach of valuation

 Another popular valuation model is price to earnings ratio (PE). It

also called earnings multiple because it states price of a share as
multiple of EPS.
 Since PE ratio =P0 /EPS, therefore PE ratio * EPS = Po , and that is
how it can be used to estimate share value
 This method of valuation of share assumes that PE ratio of a co is
stable over time; and multiplying EPS by PE ratio gives an estimate
of share price. This model uses the logic that price of share
depends on earnings per share, and companies whose EPS is higher
should have higher price while its PE ratio is constant.
 Usually the prospects for future growth is given as reason for this
difference in earnings valuation
Earnings Multiple Approach of valuation

 It implies that market believes co Y is likely to grow much faster in

future than co Z, and that is why earnings of co Y are considered
more valuable today as these earnings are likely to grow faster in
future, and therefore owner of share of co Y are likely to enjoy
fast growth in earnings in future years and therefore higher DPS in
future years and also higher share price in future. Therefore, it is
argued that, it makes sense to pay more now to get ownership
right of such a company whose growth prospects are brighter.
P/E ratio & DDM
PE ratio = d / (Kc – g).
 Note: DPS / EPS = d, dividend payout ratio.
 This expression of PE ratio clearly shows that PE ratio has 3
drivers:
1) Dividend payout ratio (d) positively affects PE ratio
2) Required rate of return of shareholders (Kc) negatively
affects PE ratio
3) Growth rate (g) positively affects PE ratio. Thus companies
that are expected to grow faster in future years are likely to
have higher PE ratio now, implying that companies with slow
future growth prospects are likely to have low PE ratio now.
Use of P/E ratio in identifying
undervalued shares
 Generally it is believed that relatively high PE ratio for a stock
indicates high growth prospects for that company, and low PE
stocks have relatively low growth prospects.
 But on the other hand high PE ratio may indicate overvalued stock
and low PE ratio may indicate undervalued stock. Then the
question arises if high PE ratio means expected high growth of
share price and also over valuation at the current price then how
come overvalued share is expected to grow in price because
common sense tells us that overvalued shares are expected to
experience a fall in their price not an increase.
 Actual Trailing P/E Ratio
 Actual Leading P/E ratio
 Intrinsic Leading P/E Ratio
Actual Leading Vs Intrinsic Leading P/E

 If actual leading PE ratio is greater than intrinsic leading PE ratio,

then the share is overvalued at its current market price.
 If actual leading PE ratio is greater than the intrinsic leading PE
ratio, then actual price of share is more than the intrinsic value of
that share; and therefore the share is over valued at its current
market price.
 It is only common sense that you search for the undervalued
shares as an investor, and you like to buy such shares; and
overvalued shares are not bought and not to be included in your
portfolio as an individual investor.
Intrinsic Leading PE Ratio

 Intrinsic leading PE ratio = Tangible PE + Franchise PE

1. Tangible PE
Tangible PE ratio refers to a situation where co does not
reinvestment its profits, rather all the NI is given out as
cash dividends, the resulting PE is based on perpetual use
of existing assets, and resulting earnings or profits from
the productive use of such non growing assets. As a
consequence, d = 1.
Intrinsic Leading PE Ratio – Tangible PE

g = ROE (1 - d) = ROE ( 1 - 1) = ROE (0) = 0

Intrinsic Leading PE ratio = d / (Kc – g)
= 1 / (Kc – 0)
= 1 / Kc
Such PE ratio is called tangible PE because it is expected to be the PE
if assets of co are not growing because no portion of earnings is
retained and reinvested in the business. Here implicitly it is also the
assumption that no funds are raised as external equity by issuing
shares, or as debt; only than a constant non-growing asset base would
generate a constant non growing EPS, and all of that EPS would be
given out as cash dividends; therefore expected stream of EPS is
constant in all future years due to a non growing asset base.
Intrinsic Leading PE – Franchise PE

 It has two components:

1. Franchise Factor
Franchise factor is result of a company earning on projects financed
from RE a higher ROE than Kc, while Kc is risk adjusted ROR for share
holders. Here it is assumed that if co did no reinvestment of profits by
virtue of giving all its profits as dividends, then its PE would be equal
to tangible PE which is 1 / Kc as proven above; but as most companies
do not give all their NI in dividends and do reinvest some of their NI in
the business then company’s managers would select those promising
expansion projects which are expected to give ROE greater than Kc.
2. Growth Factor
 Intrinsic Leading PE – Franchise PE
Growth Factor
The growth factor is PV (present value) of constant growth rate attained from
reinvesting of some NI into business as addition to RE and not giving out all of NI as
dividends.
As you know from earlier lectures that growth rate of a company’s OE can translate
into growth rate of its Sales, TA, TL, NI, EPS, DPS, and ultimately growth rate of share
price if 5 policies are kept constant & you have already learnt that such growth rate
can be quantified as:
g = ROE * (1 – d).
Thus, Gordon’s formula for fair value of share:
Po = DPS1 / (Kc – g)
Becomes:
Po = DPS1 / [Kc – ROE * (1- d)]
Intrinsic Leading PE
  
1. is called Tangible PE ratio
2. is called franchise factor; and it represents competitive advantage of a
business over its competitors.
3. is called growth factor.
Intrinsic Leading PE = Tangible PE + Franchise PE
Franchise PE ratio = Franchise factor * Growth factor
Intrinsic Leading PE – Conceptual
Understanding
 If Franchise Factor is positive it means co has competitive advantage in the
product market and if it is negative then it means co has a competitive
disadvantage in the product market.
 Bigger franchise factor means ability of a company to earn on shareholders
invested funds a rate of return (ROE) higher than the shareholders’ risk
adjusted required rate of return (Kc).
 The underlying logic is that a company can earn ROE higher than Kc only if its
management selects promising projects, and in NWC + FA of such projects it
invests retained earnings; and then manages these projects ( such as new
product lines and new factories) in a manner that it ends up earning a ROE
higher than Kc from these projects due to superior product offering, better
quality, cost control in production, better marketing, and better innovation
according to consumers’ needs.
Intrinsic Leading PE - Example

 ROE 15%, dividend payout ratio (d) is 70%, NI expected for next year 100
million, market value of its equity is 600 million Rs. Shareholders require a
risk adjusted ROR from share of this Co , Kc, 20% which was estimated using
CAPM.
 Please Find: growth rate ‘g’; Tangible PE, franchise factor, growth factor,
franchise PE, and intrinsic Leading PE, Actual Leading PE ratio, your verdict
about over or under valuation of this share on its current price. (note: current
share price (P0) is deliberately not given here to test your understanding)
Intrinsic Leading PE - Example

 ROE 15%, dividend payout ratio (d) is 70%, NI expected for next year 100
million, market value of its equity is 600 million Rs. Shareholders require a
risk adjusted ROR from share of this Co , Kc, 20% which was estimated using
CAPM.
 Please Find: growth rate ‘g’; Tangible PE, franchise factor, growth factor,
franchise PE, and intrinsic Leading PE, Actual Leading PE ratio, your verdict
about over or under valuation of this share on its current price. (note: current
share price (P0) is deliberately not given here to test your understanding)
 g = ROE ( 1 - d) = 15% (1 - 0.7) = 4.5%
 Tangible PE ratio = 1 / Kc = 1 / 0.2 = 5 times
Intrinsic Leading PE - Example

Franchise factor = 1/Kc – 1/ROE

= 1/0.2 – 1/.15
= 5 – 6.67 = -1.67

Growth factor = g / (kc – g)

= 0.045 / (0.2 – 0.045)
= 0.045 / .155 = 0.29
Intrinsic Leading PE - Example

Franchise PE ratio = franchise factor * growth factor

= -1.67 * 0.29
= -0.48
Intrinsic Leading PE - Example

Franchise PE ratio = franchise factor * growth factor

= -1.67 * 0.29
= -0.48

Intrinsic Leading PE ratio = Tangible PE ratio + Franchise PE

ratio
=5 + (- 0.48)
= 4.52
Intrinsic Leading PE - Implications

 In this case growth factor (0.29) is very small; and franchise factor
depicting the ability to earn ROE higher than Kc is negative ( - 1.67)
implying poor competitive advantage of this company in the product
markets.
 Therefore overall contribution to valuation of attaining growth in business
by reinvesting profits in the business is negative as depicted by negative
franchise PE.
 Also note: if this co had decided not to reinvest profits, and had given out
all of its NI in dividends, then its PE would have been higher, that is, 5 as
shown its tangible PE ratio
Intrinsic Leading PE – Investing Decision

Actual Leading PE ratio = P0 / EPS1

Since per share data is not given, we can use total amounts of
expected NI of next year instead of EPS and total MV of equity instead
of MV per share , that is P0.

Actual Leading PE ratio = MV of equity now / NI1

= 600 / 100
= 6
Intrinsic Leading PE – Investing Decision

Actual Leading PE ratio = MV of equity now / NI1

= 600 / 100
= 6
Decision : Since,
Actual leading PE > Intrinsic leading PE
6 > 4.52
Actual price is greater than theoretical price (or fair value, or intrinsic
value), and the share of this co is overvalued at its current price in the
market and you should not invest in it; rather wait for fall in its price
because overvalued assets are expected to experience decline in their
market price: once that happens then it would be ok to buy it.
Important Lesson

 It is not growth in business per- se that creates value for the

shareholders (makes shareholders wealthier), but only profitable growth
creates value, and such growth is experienced by a co only if managers
identify and then invest in new projects that earn ROE greater than Kc,
only then value would be created for the shareholders; and intrinsic PE
would be higher than tangible PE, or in other word PE with growth would
be higher than the PE without growth.
 Otherwise growth can turn into a value destroying phenomenon instead
of a value creating phenomenon, as was the case in this example
Practice Questions

 ROE 25%, dividend payout ratio (d) is 50%, NI expected for next year 120
million, market value of its equity is 680 million Rs. Shareholders require a
risk adjusted ROR from share of this Co , Kc, 15% which was estimated using
CAPM. Find: growth rate ‘g’; Tangible PE, franchise factor, growth factor,
franchise PE, and intrinsic Leading PE, Actual Leading PE ratio, your verdict
about over or under valuation.
Practice Questions

 OE = 350, Dividends = 50, NI expected for next year 120 million, market value
of its equity is 680 million Rs. Shareholders require a Beta of 1.2 from share
of this Co , Rf is 5%, Rm is 10% which was estimated using CAPM. Find: growth
rate ‘g’; Tangible PE, franchise factor, growth factor, franchise PE, and
intrinsic Leading PE, Actual Leading PE ratio, your verdict about over or under
valuation.
Practice Questions

 OE = 350, Dividends = 50, NI expected for next year 120 million, market value
of its equity is 680 million Rs. Shareholders require a Beta of 1.2 from share
of this Co , Rf is 5%, Rm is 10% which was estimated using CAPM. Find: growth
rate ‘g’; Tangible PE, franchise factor, growth factor, franchise PE, and
intrinsic Leading PE, Actual Leading PE ratio, your verdict about over or under
valuation.