• Price-earnings ratio
• Price-book ratio
• Price-revenues ratio and other ratios
• Market efficiency

Different aspects of a company's financial performance serve as a surrogate for the business's overall value or price. For many investors, who view earnings as a good indicator of future returns, price is set on the basis of earnings. For some investors, the assets of the company (or book value) provide a better measure of future returns.

The trick, though, is figuring out what companies are comparable.

The price-earnings ratio is a multiplier that expresses the amount investors will pay for a dollar of current earnings. It can be used to value a company (often privately held) by identifying public companies in the same or similar lines of business and deriving a multiple that relates the public company's market price to its earnings.

This means that if you know a private company's current earnings, as well as the market price and current earnings of similar public companies, you can calculate the market-based price of the private company's stock. The P/E formula is simple. It merely assumes that two similar companies (X and Y) will have an equal ratio of price to earnings:

OR

For publicly-traded companies (or those for which there is data on market transactions) investors often look at the relationship between the company's trading price and its earnings. This relationship, known as the Price/Earnings (P/E) ratio, allows a valuator to compute the value of a company or its stock by knowing three things: the company's earnings, and a comparable company's price and earnings.

But the PE ratio can be misleading, particularly for publicly-traded stock. It typically is based on last year's earnings -- which may not reflect this year's or future earnings -- and investors, after all, are only interested in future earnings. If a company has had a stable PE ratio, this suggest a capitalization multiplier for its traded stock. Be careful, though. The stock's P/E ratio does not tell us the value of the overall business, including control.

If you believe that investors would view X and Y to be investments of comparable risk -- that is, the expected rates of return for X and Y will be comparable -- you can use information about one company to determine the price of the other.

Some caveats. P-E ratios can be misleading. For example, a company with a stock price of $24, but zero earnings in the prior year, has an infinite price/earnings ratio. But this cannot mean that comparable companies with positive earnings should have an infinite price! It may have been that the prior year was a transition year for the company. Moreover, although averaging the company's price and earnings with those of other companies to arrive at an industry P/E ratio may control for individual variations, the industry average might be misleading if the industry had a particularly good or bad year. The industry average may also reflect price and earnings information for many diversified companies with only some operations in the relevant industry.

Rules of thumb. Over time, stock valuators have developed some rules of thumb, based on earnings and dividends. Some valuators say that [examples - "steel companies generally sell for 8 times earnings / software companies sell for 25 times earnings] The most famous homespun rules come from Benjamin Graham, the stock-picker from whom Warren Buffet says he learned "value investing." [see Brudney at p 550].

P/E ratios can be found in a number of sources. See [hyperlinks to investment web pages] Standard & Poor's Industrial Ratios.

Happy Burgers is a national chain of franchised fast-food restaurants. All of its stores and menus have the same look and feel -- it's advertising logo is "seen one Happy Burger, seen 'em all."

A Happy Burgers franchise owner in Columbus, Ohio is interested in selling her business and learns that in the past 6 months three other Happy Burgers franchises were sold in Indianapolis, Topeka and Spokane. The price paid in each sale, compared to the franchise's last-year net earnings, was 14.6, 13.6 and 15.2. In each case, the other franchises were in neighborhoods similar to that of the Columbus franchise and their earnings growth was a similar 5.8%. If the Columbus franchise had net earnings last year of $450,000, how much should the owner expect to get?

This means that $450,000 in earnings should produce a price of $6,600,000.

What is the discount rate for this company - assuming you wanted to use a traditional DCF analysis?

Notice that the imputed capitalization rate alone is not enough to know the discount rate, since the P/E ratio assumes that growth is already figured into the pricing of a company.

An interesting puzzle

Which of the following two hypothetical companies produces more earnings, per dollar invested, over the next five years?

• Firm A, whose earnings are projected to grow 10 percent per year, and whose stock is trading at a price/earnings ratio of 15.
• Firm B, whose earnings are projected to grow 25 percent per year, and whose stock is trading at a P/E ratio of 35.

The answer, believe it or not, is ... (more>>)

Example

In 1986, when Microsoft went public, other companies selling software for personal computers had the following market prices and current earnings:

Microsoft's current earnings/share was xxx. Assuming that Microsoft's riskiness and growth prospects were comparable to these other companies, what should its initial offering price have been?

Answer:

"If We Understand the Mechanisms, Why Don't We Understand Their Output?"
Journal of Corporation Law, Forthcoming

BY: ALLEN FERRELL
Harvard Law School

Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=393683