What do you expect to drive a company’s price-to-book equity and price-to-earnings equity? Price-to-book multiples are a function of future abnormal ROEs, book value growth and the organisation’s cost of equity * Future abnormal ROE: ROE less the cost of equity capital (ROE – re). Organisations with positive abnormal ROE are able to invest their net assets to create value for shareholders and have price-to-book ratios greater than one. Organisations’ long-term ROEs are affected by such factors as barriers to entry in their industries, change in production or delivery technologies, and quality of management. These factors tend to force abnormal ROEs to decay over time.
* Beginning book value growth: the magnitude of an organisation’s price-to-book multiple also depends on the amount of growth in book value. Organisations can grow their equity base by issuing new equity or by reinvesting profits.If this new equity is invested in positive value projects for shareholders – that is, projects with ROEs that exceed the cost of capital – the organisation will boost its price-to-book multiple. Of course, for organisations with ROEs that are less than the cost of capital, equity growth further lowers the multiple. Price-to-earnings multiples The driver of both current and future P/E ratios is the sum of the change in abnormal earnings, scaled by the current period’s net income.As change can be positive or negative, only the direction and magnitude of the expected change matters.
* Change in abnormal earnings * ? RE2 = E2 – [E1 + r(E1 – D1)] * E2 = Earnings earned in period 2 * [E1 + r(E1 – D1)] = normal earnings expected to be earned in period 2 Q2. Match the price-to-book equity valuation multiple. Restaurant| P/B value| A| 4. 4| C| 3. 9| B| 1.
0| D| 1. 0| With the data provided, P/B values are mainly affected by ROE trend, holding other drivers constant.By plotting the trend of each restaurants, we can clearly see which of them has higher ROE values and therefore P/B values. Q3.
Match the price-to-earnings equity valuation multiple. Restaurant| P/B value| C| 4. 4| A| 3. 9| D| 1. 0| B| 1.
0| Assuming: * r is constant because all these restaurants are in the same industry and therefore have similar rates of return * E0 = 1, this is because all annual sales growth is denoted as a % A: Increasing growth, albeit slowly Many new restaurants opened each year, but the slow growth seem to suggest the market is getting saturated B: High growth, sharp decrease in ‘01 * Saturated industry, seems like ’01 it added 11 restaurants but were all not successful C: Slowly declining, but still high * Industry not mature yet, therefore the large growth. Slowly declining as more entrants enter into this market D: Growth peaked in ’00 and has since been on decline * Saturated industry, like B but it’s decline is more slow
