PE Ratio

1
P/E Ratio

• Basic Dividend Discount Model P E(1-K)/(r-g)
• P/E Ratio Payout Ratio/ r g
• P/E is higher for high growth companies
• P/E is lower for companies with riskier cash
  flows to equity holders
• Useful to spot mispricing when
• Growth rates are similar
• Capital structure is similar
• It can be used only when earnings are positive

2
P/E Ratio with No Growth

• Current P/E and discount rate of 10
• P/E (1r)/r 11
• Forward P/E and discount rate of 10
• P/E 1/r 10
• Assuming a discount rate of 10
• When a firm has a P/E greater than 11 than the
  market implies the firms earnings should grow
• A P/E below 11 implies falling future earnings

3
P/B Ratio

• Price/Book Price/Earnings Earnings/Book
• Earnings / Book value of equity ROE
• P/B P/EROE
• A high growth firm may have a low P/B multiple if
  firm has low returns (ROE)
• Useful for valuing companies not in technical
  default
• Useful valuation metric for financial services
  companies

4
Why would a company ever sell for P/B lt 1

• Accounting statements do not accurately reflect
  true net asset value of firm.
• Firm is losing money and is likely to continue to
  do so in the future.
• Or
• Firm could be undervalued(classic value
  investing)

5
EV/EBITDA Ratio

• Enterprise value Market Value of Equity net
  debt (Debt Financial Assets)
• Value of the operating assets of the firm
• EBITDA Earnings before interest, taxes,
  depreciation and amortization
• Adjusts for both operating and financial leverage
  by calculating earnings before fixed charges
• EBITDA can be positive even when the company is
  not profitable

6
Putting it Together
Slide Taken From Professor Lehavys Acc 712
Lectures

• P/B P/E ROE

7
Historical P/E and P/B ratios

• From 1974 to 2004 average P/E was 13.5
• Top 25 were above 21.9
• Bottom 25 were below 8.6
• From 1974 to 2004 average P/B was 1.5
• Top 25 were above 2.5
• Bottom 25 were below .93
• Where are we now?
• SP 500 P/E 17.58
• SP 500 P/B 2.85

8
C/O Eugene Suk