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F I G U R E 12.6 40
Price“earnings ratios
35

30

Sun
25
P/E ratio




20

15
Con Ed
10

5

0
1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999




industry are computed in two ways: by taking the ratio of price to previous year earnings, and
projected next-year earnings. Notice that while the P/E ratio for information technology firms
based on 2001 earnings appear quite high, the ratio is far more moderate when prices are com-
pared to projected 2002 earnings. This should not surprise you, since stock market prices are
based on firms™ future earnings prospects.
Bodie’Kane’Marcus: IV. Security Analysis 12. Equity Valuation © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




437
12 Equity Valuation




70
65.4
2001 earnings
60
2002 earnings
50
38.8
P/E ratio




40
30.9
30.2
30 25.5
24.3
24.2
21.4 20.7
21.7
18.4 17.4
20 15.5
15.6
13.4 14.9
14.9 14 12.6
13.2
10

0
Cyclical Noncyclical Cyclical Noncyclical Financials Industrials Inform- Resources Public
consumer consumer services services ation utilities
goods goods technology




F I G U R E 12.7
P/E ratios based on 2001 and 2002 EPS
Source: Thomson Financial Services, Global Comments, December 2001.




WEBMA STER
Equity Valuation
Go to the MoneyCentral Investor page at the address below. Use the Research Wizard
function to obtain fundamentals, price history, price target, catalysts, and comparison for
EMC Corporation (EMC). As comparison firms, use Network Appliance Inc. (NTAP) and
Silicon Storage (SSTI).
1. What has been one-year sales and income growth for EMC?
2. What has been the company™s five-year profit margin? How does that compare
with the comparison firms?
3. What have been the percentage price changes for the last 3, 6, and 12 months?
How do they compare with the comparison firms?
4. What is the estimated high and low price for EMC for the coming year using EMC™s
current P/E multiple?
5. Compare the price performance of EMC with NTAP and SSTI. Which of the
companies appears to be the most expensive in terms of current earnings?
Which of the companies is the least expensive in terms of current
earnings?
http://moneycentral.msn.com/investor/home.asp
Bodie’Kane’Marcus: IV. Security Analysis 12. Equity Valuation © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




438 Part FOUR Security Analysis


Combining P/E Analysis and the DDM
Some analysts use P/E ratios in conjunction with earnings forecasts to estimate the price of
stock at an investor™s horizon date. The Raytheon analysis in Figure 12.2 shows that Value
Line forecasted a P/E ratio for 2005 of 13.0. EPS for 2005 were forecast at $4.25, implying a
price in 2005 of 13.0 $4.25 $55.25. Given an estimate of $55.25 for the 2005 sales price,
we would compute Raytheon™s intrinsic value as
$0.80 $0.95 $1.10 $1.25 $55.25
V2001 $38.43
(1.118)2 (1.118)3 (1.118)4
(1.118)
which is fairly close to the recent market price.

Other Comparative Valuation Ratios
The price“earnings ratio is an example of a comparative valuation ratio. Such ratios are used
to assess the valuation of one firm versus another based on a fundamental indicator such as
earnings. For example, an analyst might compare the P/E ratios of two firms in the same in-
dustry to test whether the market is valuing one firm “more aggressively” than the other. Other
such comparative ratios are commonly used.

Price-to-book ratio This is the ratio of price per share divided by book value per share.
As we noted earlier in this chapter, some analysts view book as a useful measure of value and
therefore treat the ratio of price-to-book value as an indicator of how aggressively the market
values the firm.

Price-to-cash flow ratio Earnings as reported on the income statement can be affected
by the company™s choice of accounting practices and thus are commonly viewed as subject to
some imprecision and even manipulation. In contrast, cash flow”which tracks cash actually
flowing into or out of the firm”is less affected by accounting decisions. As a result, some an-
alysts prefer to use the ratio of price to cash flow per share rather than price to earnings per
share. Some analysts use operating cash flow when calculating this ratio; others prefer free
cash flow, that is, operating cash flow net of new investment.

Price-to-sales ratio Many start-up firms have no earnings. As a result, the P/E ratio for
these firms is meaningless. The price-to-sales ratio (the ratio of stock price to the annual sales
per share) is sometimes taken as a valuation benchmark for these firms. Of course, price-to-
sales ratios can vary markedly across industries, since profit margins vary widely.

Figure 12.8 presents the behavior of these valuation measures since 1955. While the levels
of these ratios differ considerably, for the most part they track each other fairly closely, with
upturns and downturns at the same times.

Be creative Sometimes a standard valuation ratio will simply not be available, and you
will have to devise your own. In the 1990s, some analysts valued retail Internet firms based on
the number of Web hits their sites received. In retrospect, they valued these firms using too
generous “price-to-hits” ratios. Nevertheless, in a new investment environment, these analysts
used the information available to them to devise the best valuation tools they could.

Free Cash Flow Valuation Approaches
How might we value firms in the earliest stages of their life, for example, firms not currently
paying dividends? In these cases, one approach is to discount the stream of free cash flow for
Bodie’Kane’Marcus: IV. Security Analysis 12. Equity Valuation © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




439
12 Equity Valuation




35

30 P/E

25

20
Ratio




15
Price/CF
10

5 Price/Sales

0
1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000




F I G U R E 12.8
Market valuation statistics


the firm (FCFF) at the weighted-average cost of capital, and then subtract the value of debt to
obtain the value of equity:
FCFF EBIT (1 Tax rate) Depreciation Capital expenditures Increase in NWC
where
EBIT earnings before interest and tax,
NWC net working capital.
We emphasize that this approach is fully consistent with the dividend discount model and
ought to provide the same value estimate if one could extrapolate to a period in which the firm
begins to pay dividends. However, for very young firms that do not pay dividends, this ap-
proach is more convenient.
We might also discount free cash flows to equity (FCFE) at the cost of equity, kE:
FCFE Net income Depreciation Capital expenditures Increase in NWC
Principal repayments New debt-issue proceeds
FCFEt Pn FCFEn 1
n
P0 where Pn
(1 kE)t (1 kE)n kE g
t 1

Notice that we need to compute a terminal value to avoid solving an infinite sum. That ter-
minal value may simply be the present value of a constant growth perpetuity (as in the formula
above) or it may be based on a multiple of EBIT, book value, earnings, or FCFF. As a general
rule, these estimates of value depend critically on terminal value.


12.5 THE AGGREGATE STOCK MARKET
The most popular approach to forecasting the overall stock market is the earnings multiplier
approach applied at the aggregate level. The first step is to forecast corporate profits for the
coming period. Then we derive an estimate of the earnings multiplier, the aggregate P/E ratio,
Bodie’Kane’Marcus: IV. Security Analysis 12. Equity Valuation © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




440 Part FOUR Security Analysis

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