Chapter 6 Set 3

Price Ratio Models

Price Ratio Analysis

Price-earnings ratio (P/E ratio): Current stock

price per share divided by annual earnings per
share (EPS)

Earnings yield: Inverse of the P/E ratio, i.e.,

earnings per share (EPS) divided by price per share
(E/P)

High-P/E stocks are often referred to as growth

stocks, while low-P/E stocks are often referred to as
value stocks.
Price Ratio Analysis

P/E ratios are not stable.

If a company has a one-time write-off that significantly reduces earnings, then
since it is just a one-time event, share price will not drop significantly but
earnings will. This results in a big increase in P/E but doesnt mean that the
company is a growth stock.
If the company has a one-time positive impact on earnings, then share price will
not increase significantly but earnings will. This results in a big decrease in P/E
but doesnt mean that the company is a value stock.

Thus, the conclusion, that High-P/E stocks are often referred to as

growth stocks while low-P/E stocks are often referred to as value
stocks, may not be always true.

Use PEG ratio instead of P/E ratio.

Many market participants and fund managers often calculate the PEG ratio. PEG
ratio = P/E ratio divided by growth rate.
Taking a growth rate into the calculation, PEG ratio provides a better method to
compare companies whose growth rates are different.
Price Ratio Analysis

Price-cash flow ratio (P/CF ratio)

Current stock price divided by current cash flow per
share
In this context, cash flow is usually taken to be net
income plus depreciation.

Most analysts agree that in examining a

companys financial performance, cash flow can
be more informative than net income.

Earnings and cash flows that are far from each

other may be a signal of poor quality earnings.
Price Ratio Analysis

Price-sales ratio (P/S ratio)

Current stock price divided by
annual sales per share
A high P/S ratio suggests high
sales growth, while a low P/S ratio
suggests sluggish sales growth.
Price/Earnings Analysis

Pthis year = * Ethis year

= use the average P/E ratio calculated based on
prices and earnings from the past
several years

Ethis year = Elast year x (1 + expected earnings growth rate

of this year)

The expected earnings growth rate for this year is

estimated by using the average earnings growth
Price/Earnings Analysis

P2017 = * E2017
= use the average P/E ratio calculated based on
prices and earnings from the past
several years

E2017 = E2016 x (1 + expected earnings growth rate

of 2017)

The earnings growth rate for the year of 2017 is

estimated by using the average earnings growth
 Conclusion

Using Earnings to estimate stock price:

Pthis year = Ave * [Elast year * (1+ Ave Earnings
growth rate)]

Using Cash Flows(CF) to estimate stock

price:
Pthis year = Ave * [Cflast year * (1+ Ave CF
growth rate)]
Using Sales(S) to estimate stock price:
P = Ave * [S * (1+ Ave Sales
Conclusion

Using Earnings to estimate stock price:

P2017 = Ave * [E2016 * (1+ Ave Earnings
growth rate)]

Using Cash Flows(CF) to estimate stock

price:
P2017 = Ave * [CF2016 * (1+ Ave CF
growth rate)]
Using Sales(S) to estimate stock price:
Problem #21, p. 217
 Problem #21, p. 217

Seger Corporation - Earnings (P/E) Analysis

6-year average P/E ratio 18.54

Current EPS $8
Average EPS growth rate 13.12%

Expected stock price = historical P/E ratio projected

EPS
where projected EPS = current EPS * (1 + average EPS
growth rate)

$167.80 = 18.54 ($8 (1+0.1312))

 Problem #21, p. 217

Earnings Cash Flow Sales

Six-year
average price
18.54 11.16 1.712
ratio
Current value
per share
8 13.1 78.7
(2013)
Six-year
average
13.12% 12.57% 8.58%
Growth rate
Expected
share price
167.80 164.61 146.30