franchise P/E value = FF x G = 2.31 x 10.11 = 23.35

intrinsic P/E value = tangible P/E value + franchise P/E value = 10.00 + 23.35 = 33.35

The firm has a competitive advantage in its industry because its ROE is greater than its required return. By raising the retention ratio from 50% to 70%, thereby reinvesting more funds in the business, the firm can further exploit that competitive advantage, raising its franchise P/E, its intrinsic P/E (from 14.30 to 33.35), and its share price. This assumes that the firm can reinvest all of the retained earnings in new investments that earn at least 13%.

Inflation Effects on Valuation

LOS 37.f: Analyze the effects of inflation on asset valuation.

An analyst must start by estimating how much inflation is reflecred in a firm's net income. This is especially important since standard accounting conventions use historical costs. Without some adjustments, the reported net income figure could be misleading due to the mixture of historical costs and inflation. For example, if a firm reports revenue based on selling prices in the market (which include inflation) and reports depreciation expense (which is based on historical cost), net income would be overstated.

To analyze the effects of inflation on P/E ratios (and stock prices), we need to determine what portion of inflation in its input prices the firm can pass on to its customers in the form of higher prices. A full-flow-through firm is one in which earnings reflect all price changes, so in the absence of real growth, earnings are growing at the inflation rate. A firm wirh an inflation flow-through of 70% can only pass 70% of inflation through to its earnings.

The following P/E equation demonstrates the effects of inflation on leading P/E:

£j real required return + j(l — inflation flow-through rare) X inflation rate]

All other things being equal, the higher the inflation flow-through rare, the higher the value of the firm. Also, the higher the inflation rare, the lower the value of the firms shares if full inflation pass-through does not occur (i.e., the inflation flow-through rate is less than 100%), all else equal.

Example: Effect of inflation flow-through rate on valuation

Pass-Through Partners and Partial Manufacturing are both based in countries with a 3% inflation rate. The real rate of return required by investors from both companies is 5%. Pass-Through Partners can pass through 100% of the inflation rate, bat, due to government restrictions, Partial Manufacturing can only pass through 60%. Calculate the estimated P/E ratios for both firms.


Partial Manufacturing has a lower valuation (i.e., a lower P/E) because it can only pass through 60% of inflation, whereas Pass-Through Partners can pass through the full effects of inflation.

Example: Effect of inflation on valuation

Stable Price, Inc. is based in a country with a 2% inflation rate, and High Price, Inc. is based in a country with a 9% inflation rate. The real rate of return required by investors from both companies is 7%. Both Stable Price and High Price can pass on 90% of inflation through to their earnings. Calculate the estimated P/E ratios for both companies.


Stable Price has a higher valuation (i.e., a higher P/E ratio) than High Price because it is in a country with lower inflation.

Multifactor Models

LOS 37.g: Discuss multifactor models as applied in a global context.

Multifactor models utilize more than one factor to explain asset returns, as illustrated in the following equation:

r = expected return on security

Ot = constant intercept term

F,___F. = factor risk premiums common to all securities

3,...3k = security's sensitivity to each factor £ = error term

Using a multifactor model to analyze risk in a global context requires at least two factors, namely country and industry. The country factor could be modeled using specific blocks of neighboring countries or simply individual countries. The same can be done for modeling the industry factor—using groups of similar industries or individual industries. Also, the industry factor may be modeled by the return on a global index in that particular industry.

There are two ways to model the risk exposures (the factor sensitivities) for the country and industry factors:

• Use specific information about the company (e.g., a mining company would likely have 100% exposure to the mining industry factor and 0% exposure to all other indusrry factors).

• Estimate the factor sensitivities with multiple linear regression.

Professor's Note: In our topic review of international asset pricing in Study Session 18 we discuss currency exposure of firms and industries. In Study Session 3 we give you everything you want to know (and more) about multiple linear regression.

There are three other factors thar could be considered, but extreme caution needs to be taken when trying to apply them in a global setting. This is due to potentially significant differences between countries in terms of criteria used to classify stocks in certain categories (e.g., a "big" firm in New Zealand may not be a "big" firm in Japan).

• The momentum effect suggests that the past short-term performance of firms predicts the future short-term performance.

• The size effect suggests that the returns for small firms are significantly different from the returns for large firms.

• The value effect suggests that the returns on value stocks are different from growth stock returns (value shares have a low price-to-book value ratio, while growth shares have a high price-to-book value ratio).

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