Common Stock Valuation Chapter 9 Lecture 17 Common Stock Valuation Chapter 9

P/E Ratio An alternative to DDM is relative valuation. Measures such as P/E value stocks in comparison to some benchmark such as the market, industry or stocks historic value over time.

P/E Ratio It is commonly used technique among practitioners, stock traders, and analysts. It always appears in report from a stock advisor. P/E ratio means how much price investors are willing to pay for one rupee of earning. If PSO had earnings of Rs.80 per share in 2007, it market price was Rs.400. What is its P/E ratio?

P/E Ratio P/E = 400/80 = 5 How is the ratio interpreted? It means for one rupee earnings investors are willing to pay Rs.5 to buy one share of PSO.

Determinants of P/E ratio To understand the determinants of P/E ratio, consider a constant growth model of DDM Dividing both side of the equation on expected next years earning, E1

Determinants of P/E ratio Other things remaining constant, 1: higher expected dividend payout? 2 ? 3 ?

P/E Ratio : Growth and risk P/E ratio reflect investors optimism or pessimism about a stock Companies with high P/E ratio are considered growing companies or less risky companies, this is the reason why investors pay higher.

Valuation using P/E ratios First P/E should be calculated with current earnings and price of stock. Then find estimated earnings in the coming year i.e. E1 Intrinsic Value = P/E x E1 The security should be purchased if IV is equal to or greater than the current market value. Estimates of next years earnings can be obtained from analysts, investment advisory services or can be calculated through growth rate in earnings.

Valuation using P/E ratios Suppose PSO current EPS is 80 per share and future earning estimate is Rs. 100 per share, current market price is 400. The current P/E Ratio = 400/80 = 5 What is the expected price of PSO, one year from now? Should an investor buy the PSO stock?

Investment Decision An investor can make the investment decision on the basis of P/E in relations to: Company’s Earning Or Industry P/E In the previous example, what should be the price of PSO based on its own P/E?

Company’s Earnings The P/E was = 5x P/E = Price/Earning Price = (P/E)x future Earnings = 5 x 100 = 500 Current price is 400, so we should buy it

Industry P/E Analysts usually calculate P/E ratio for an industry. An individual stocks’ P/E is compared with others in the industry. If it is traded at discount in relations to others, then the stock is recommended for buying.

Industry P/E Assume PSO current share price is = 400 EPS = 80, and EPS1=100 Industry P/E ratio is = 5.5 What should be the price of PSO relative to industry P/E ratio Intrinsic value = Industry P/E ratio x EPS1 = 5.5 x 100 = 550 PSO is under-priced in comparison to industry valuation and should be purchased.