Reading 42: Market-Based Valuation: Price and Enterprise Val factors, 2010, multiple, increase, following

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Session 12: Equity Investments: Valuation Models
Reading 42: Market-Based Valuation: Price and Enterprise Value Multiples

LOS i: Discuss the fundamental factors that influence each price multiple and dividend yield.

 

 

 

An increase in which of the following variables will least likley result in a corresponding increase in the price-to-book valuePBV ratio for a high-growth firm?

A) Payout ratios.

B) Required rate of return.

C) Growth rates in earnings.

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The PBV ratio decreases as the required rate of return increases.

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An increase in growth will cause a price-to-earnings (P/E) multiple to:

A) there is insufficient information to tell.

B) increase.

C) decrease.

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An increase in growth will decrease the denominator and increase the numerator in the trailing P/E expression, both of which should increase the P/E ratio:

P₀/E₀ = [(1 – b)(1 + g)] / (r – g)

Note that the reading does not allow for any interactive relationship between retention and growth. Thus, no explicit consideration is given to how the growth increase was generated.

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An increase in financial leverage will cause a price-to-earnings (P/E) multiple to:

A) increase.

B) there is insufficient information to tell.

C) decrease.

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An increase in financial leverage will cause the required rate of return to increase, thereby decreasing the P/E. This is clear in the expression for trailing P/E:

P₀ / E₀ = [(1 – b)(1 + g)] / (r – g)

(Note: the reading does not allow for any interactive relationship between leverage, return on equity (ROE), and growth. Thus, no explicit consideration is given to whether the increase in leverage would increase ROE and therefore growth through the g = (ROE × retention) relationship.)

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An increase in financial leverage, assuming no change in the growth rate, will generally cause a price to cash flow (P/CF) ratio to:

A) there is insufficient information to tell.

B) decrease.

C) increase.

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An increase in financial leverage should increase the firm’s risk and consequently its required rate of return. This should decrease the P/CF ratio, as indicated by the following expression:

P₀ / CF₀ = (1 + g) / (r – g)

(Note: the reading does not allow for any interactive relationship between leverage and growth. Thus, no explicit consideration is given to whether the increase in leverage would increase return on equity (ROE) and therefore growth through the g = (ROE × retention) relationship.)

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An increase in return on equity (ROE) will cause a price-to-book (P/B) multiple to:

A) decrease.

B) increase.

C) there is insufficient information to tell.

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An increase in ROE should increase the price to book (P/B) ratio:

P₀ / B₀ = (ROE – g) / (r – g)

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All other variables held constant, the price-to-book value (PBV) ratio will decrease with a decrease in:

A) retention ratio.

B) required rate of return.

C) expected growth rate.

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All other variables held constant, a decrease in expected growth rate will result in a decrease in PBV ratio.

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A decrease in the earnings retention rate will cause a price-to-sales (P/S) multiple to:

A) increase.

B) decrease.

C) remain the same.

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A decrease in the earnings retention rate will increase the following expression for P/S due to the implied increase in the payout ratio, which is (1 – b):

P₀ / S₀ = [(E₀ / S₀)(1 – b)(1 + g)] / (r – g)

Note that the reading does not allow for any interactive relationship between retention and growth. Thus, no explicit consideration is given to whether the increase in the payout ratio will cause an offsetting decrease in growth.

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An increase in growth will cause a price to cash flow multiple to:

A) increase.

B) decrease.

C) there is insufficient information to tell.

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An increase in growth increases the price to cash flow ratio (CF), as indicated by the following expression:

P₀ / CF₀ = (1 + g) / (r – g)

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The net impact of an increase in payout ratio on price-to-book value (PBV) ratio cannot be determined because it might also:

A) decrease expected growth.

B) decrease the market value of the firm.

C) decrease required rate of return.

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If payout increases, the growth of the firm may slow down, because internally generated funds are not being invested in new, profitable projects. Hence, the net impact on the PBV ratio from change in payout ratio cannot be determined.

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The price-to-book value (PBV) ratio for a high-growth firm will:

A) increase as the growth rate in either the high-growth or stable-growth period decreases.

B) increase as the growth rate in either the high-growth or stable-growth period increases.

C) increase as the growth rate in the high-growth period increases and decrease as the growth rate in the stable-growth period increases.

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The PBV ratio for a high-growth firm will be determined by growth rates in earnings in both the high-growth and stable-growth periods. The PBV ratio increases as the growth rate increases in either period.