Combining PE Analysis and the DDM

Some analysts use P/E ratios in conjunction with earnings forecasts to estimate the price of a stock at an investor's horizon date. The Motorola analysis in Figure 18.2 shows that Value Line forecasted a P/E ratio for 2004 of 25. EPS for 2004 were forecast at $2.20, implying a price in 2004 of 25 X $2.20 = $55. Given an estimate of $55 for the 2004 sales price, we would compute Motorola's intrinsic value as

V = $.17 + $.183 + $.197 + $.21 + $55 = $ V2000 (1.138) + (1.138)2 + (1.138)3 + (1.138)4 $33.34

which turns out to be equal to Motorola's 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 industry to test whether the market is valuing one firm "more aggressively" than the other. Other such comparative ratios are commonly used:

CHAPTER 18 Equity Valuation Models 583

Figure 18.4 Earnings growth for two companies.

CHAPTER 18 Equity Valuation Models 583

Figure 18.4 Earnings growth for two companies.

Figure 18.5

Price-earnings ratios.

Figure 18.5

Price-earnings ratios.

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 value 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

584 PART V Security Analysis

Figure 18.6 P/E ratios.

Figure 18.6 P/E ratios.

Figure 18.7 Market valuation statistics.

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a result, some analysts 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 price-earnings ratio for these firms is meaningless. The price-to-sales ratio (the ratio of stock price to the annual sales per share) has recently become a popular valuation benchmark for these firms. Of course, price-to-sales ratios can vary markedly across industries, since profit margins vary widely. Nevertheless, as the nearby box indicates, use of this ratio has increased substantially in recent years.

Figure 18.7 presents the behavior of these valuation measures since 1955 for the broad market. 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.

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