Class Business



Upcoming Case
Clip
Proforma Assignment
Quality of Earnings:
Areas of Accounting Choices






Allowance for bad debts
Non-securing items
Reserves management
Stock options
Revenue recognition
Off-balance sheet assets and liabilities
Price Earnings Ratios


P/E Ratios are a function of two factors
– Required Rates of Return (k) or risk
– Expected growth in Dividends
Uses
– Relative valuation
– Extensive Use in industry
PE Ratios

Define P/E ratio at time t as
 P  Pt
 
 E t Et 1

What does PE ratio tell us?
When prices are equal to intrinsic values
E1
 PVGO
k
which implies
P0 
P0 1  PVGO 
 1 

E1 k 
E1 / k 
PE Ratios

The higher the PVGO, the higher the PE ratio holding all else
constant.
P0 1  PVGO 
 1 

E1 k 
E1 / k 
PE Ratios and Risk

If prices are equal to intrinsic value, and earnings growth is
constant:
D1 E1 (1  b)
P0 

kg kg
which implies
P 1 b

E1 k  g

The lower the risk (k), the higher the PE ratio holding all else
constant
PE Ratios and Trading


Do we always prefer stocks with high P/E ratios?
No – PE ratios tell us something about
– Relative expected growth in earnings
– Relative risk

If markets are efficient, (prices are equal to intrinsic value) then the
effects of growth and risk should already be in the stock price.

The objective as an analyst is to find stocks with high growth where
growth is not already in the price.
PE Ratios

P/E Effect: The Evidence
– Stocks with low price-earnings ratio (value stocks)
tend to outperform stocks with high price-earnings
ratio (growth stocks).
–
–
High PE stocks may be “overpriced”
Holding growth constant, low PE implies high risk
(high discount rate)
•
Low PE stocks could just be risker from a CAPM
point of view
PE Ratios

The “normal” PE ratio reported in financial press
 P  Pt
 
 E t Et
where Et is the most recent accounting earnings in the past


Not a forecast of future earnings
Subject to manipulation by accountants
Average PE Ratios (1950 - 2004)
Dividend Discount Models:
General Model

Dt
Vo  
t
t  1 (1  k )



V0 = Value of Stock
Dt = Dividend
k = required return
Constant Growth Model

g = constant perpetual growth rate
Estimating Inputs

Dividend Growth Rate (g)
– g = ROE*b
– g = growth rate in dividends
– ROE = Return on Equity for the firm
– b = plowback or retention percentage rate
•

b = (1- dividend payout percentage rate)
Required Rate of Return (k)
– Use CAPM
E[r i]  k  rf  i[E(r m) - rf]
Shifting Growth Rate Model



g1 = first growth rate
g2 = second growth rate
T = number of periods of growth at g1
Problems with Dividend Discount
Model



Firm does not pay dividends
– Valued at zero??
Firm engages in other uses of residual earnings
– Stock buybacks
– Impact on value
Look at cash flows before dividends
– Free-cash flows
•
cash flows that the company has available to certain claim
holders even if the cash flows are not directly transferred
Free Cash Flows

Free Cash Flows to the Firm (FCFF)
– Cash flows available to debtholders, equity holders
(common and preferred)

Free Cash Flows to Equity Holders
– Cash flows available to equity holders (common
and preferred)
Free Cash Flows to Firm
and Valuation
Definition:
FCFF = EBIT(1-tax rate) – (Capital Expenditures –
Depreciation) – (Change in working capital)


Valuation Steps:
– Construct forecasts of FCFF
– Obtain discount rate for cash flows (WACC)
– Construct Value of Firm
– Subtract off Market value of Debt
Free Cash Flows to Equity and
Valuation
Definition:
FCFE = Net income – (Capital Expenditures –
Depreciation) – (Change in working capital) +
(New Debt issued – Debt repayments)


Valuation Steps:
– Construct forecasts of FCFE
– Obtain discount rate for cash flows (k) - CAPM
– Construct Equity Value of Firm