032418638X 13

VALUATION: MARKET-BASED
APPROACHES
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Learning Objectives
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Chapter 13
1. Understand the practical advantages and disadvantages of

using market multiples in valuation.
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2. Apply a version of the residual income valuation model to estimate the value-to-book ratio (VB) as a theoretically correct valuation multiple. Understand how to compare the value-to-book
ratio to the market-to-book ratio (MB). Also understand how to
compare VB ratios and MB ratios to analyze values of firms
over time and to compare values across firms.
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3. Understand and estimate the firms value-earnings ratio (VE) as

a theoretically correct earnings-valuation multiple. Understand
how to incorporate growth into the VE ratio to determine the
value-earnings-growth ratio (VEG). Compare the VE and VEG
ratios to the price-earnings ratio (PE) and the price-earningsgrowth ratio (PEG). Use VE and VEG ratios and PE and PEG
ratios to evaluate firms over time and compare valuations
across firms.
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4. Understand the role of the following factors on market multiples: (a) risk and the cost of equity capital, (b) growth rates, (c)
differences between current and expected future earnings, and
(d) alternative accounting methods and principles. Use these
factors to explain how VB, VE, and VEG ratios should differ
across firms, and why MB, PE, and PEG ratios actually do differ across firms.
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5. Estimate the price differentialthe difference between market

price and risk-free value, which is computed using the residual income model and the risk-free discount rate.
Introduction and Overview
6. Reverse engineer the firms stock price by using the residual

income model to determine either the implicit expected return
or the implicit expected long-run growth rate.
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INTRODUCTION AND OVERVIEW
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7. Understand the role of market efficiency in valuation, and the

academic evidence on the degree to which the market efficiently impounds earnings information into share prices.
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Chapters 1 to 12 have all focused on using the information in a firms accounting

numbers, financial statements, and related notes to analyze the firms fundamental
characteristics of profitability, risk, growth, and value. These prior chapters have
established a coherent framework to attack a very difficult problemhow to analyze
and value a business. Using this framework to analyze and value a business, we must
first understand the firms industry and business strategy, and then we use that understanding to assess the quality of the firms accounting, making adjustments as necessary. We then evaluate the firms profitability, risk, growth, efficiency, liquidity, and
leverage, using a set of financial ratios. On the foundation of these steps, we construct
forecasts of future financial statements, from which we derive the expected future
earnings, cash flows, and dividends that form the bases for valuation. We apply the
free cash flows model, the residual income model, and the dividends model to
value the firm, and we use these models to assess the sensitivity of firm value to key
valuation parameters, such as costs of capital and expected growth rates. To culminate
this process, we describe the realistic range of firm value estimates and compare this
range of values to the firms market share price for an intelligent investment decision.
Exhibit 13.1 provides a summary representation of the fundamentals-driven valuation process. The bottom of the exhibit depicts the firms value drivers, such as
expected future earnings, cash flows, growth, and risk, which comprise the economic
foundations of valuation. We capture these value drivers in forecasts of future pro
forma financial statements, and then convert these forecasts into value estimates
using valuation models, such as the residual income model, the free cash flows
model, and the dividends model.
In this chapter, we continue our focus on the firms fundamental characteristics of
profitability, risk, growth, and value, but now we augment that analytical approach
with techniques that allow us to exploit the information in the firms market value.
We describe and apply a variety of techniques that compare the firms market value
(or share price) to firm fundamentals. The techniques we describe in this chapter
include commonly used market multiplesmarket-to-book ratios, price-earnings
ratios, and price-earnings-growth ratios. Market multiples provide efficient shortcuts to the valuation process. As Exhibit 13.2 depicts, market multiples rest on the
same foundation of value drivers in the valuation process as the valuation models
discussed in Chapters 11 and 12expected future earnings, cash flows, growth, and
riskbut market multiples collapse the valuation process in two important ways.
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Chapter 13
Valuation: Market-based Approaches
EXHIBIT 13.1
Fundamentals of Valuation
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Firm Value
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Estimate:
Book Value of Common Equity plus Present Value of Expected Future Residual Income
= Present Value of Expected Future Free Cash Flows to Common Equity Shareholders
= Present Value of Expected Future Dividends
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Pro Forma Financial Statement Forecasts
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Fundamental Value Drivers over the Remaining Life of the Firm:

Expected Future Earnings, Cash Flows, Growth, Risk
EXHIBIT 13.2
Market Multiples
Firm Value
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(1) Instead of developing complete pro forma financial statement forecasts, multiples use just one or two summary accounting numbers to represent the value
drivers.
(2) Instead of using extensive present value model computations, market multiples summarize value using relatively simple ratios of market value of common equity to summary accounting numbers.
Market Multiples:
Market-to-Book Ratios, Price-Earnings Ratios, Price-Earnings-Growth Ratios
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Summary Accounting Numbers:

Earnings; Book Value of Common Shareholders Equity; Long-run Growth
Fundamental Value Drivers over the Remaining Life of the Firm:

Expected Future Earnings, Cash Flows, Growth, Risk
Market Multiples of Accounting Numbers
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In this chapter, we also introduce techniques to infer and exploit the information
in share prices, including computing price differentials and reverse engineering share
prices. In the last section of the chapter, we briefly summarize a few key insights from
the last 40 years of accounting, finance, and economics research on how efficiently
the market uses accounting earnings to price stocks. The research findings are very
encouraging for those interested in using accounting numbers for fundamental
analysis and valuation of stocks.
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MARKET MULTIPLES OF ACCOUNTING NUMBERS
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The market price for a share of common equity is a very special and important
number: it reflects the aggregated expectations of all of the market participants following that particular stock. The market price reflects the result of the markets trading activity in that stock. It summarizes the aggregate information the market
participants have about the firm, and the aggregate expectation for the firms future
profitability, growth, and risk. The market price of a share does not mean that all
market participants agree that the price is the correct value for the share; indeed, the
market price simply indicates the equilibrium point at which the forces of supply
(participants potentially willing to sell the stockthe ask side of trading) and the
forces of demand (participants potentially willing to buy the stockthe bid side of
trading) are momentarily in balance. Stock prices are dynamic, constantly changing
with the arrival of new information that changes investors expectations about share
value and triggers trading in the firms shares in the market. We can analyze share
price for value-relevant information.
Market participants commonly calibrate firm valuation using market value or share
price expressed as a multiple of a fundamental summary accounting number, such as
the market-to-book ratio or the price-earnings ratio. Thus, market multiples capture
relative valuation per dollar of book value or per dollar of earnings. In this way, market multiples measure value relative to a key accounting number as a common denominator, thereby enabling analysts to draw inferences about a particular firms relative
market capitalization, to assess changes in relative valuation over time, to make comparisons of valuation across firms, and to make projections about comparable firms
values. For example, price-earnings ratios allow an analyst to quickly gauge and compare the multiples at which the market is capitalizing different firms annual earnings.
Market multiples can provide useful and efficient fundamental valuation ratios but
they must be applied and interpreted carefully, after considering the firms expected
future profitability, growth, and risk. Multiples like market-to-book ratios and priceearnings ratios are relative value metrics and therefore are not meaningful by themselves. For example, whether a particular firms price-earnings ratio should be 10, 20,
30, or some other number cannot be determined unless the analyst knows the firms
fundamental characteristicsexpected future profitability, growth, and risk.
Analysts sometimes apply market multiples to estimate value in ad hoc ways.
Valuation using market multiples may be efficient (the so-called quick and dirty
approach) but may also be misleading. An analyst might be tempted to value a firm
using that firms historical average or the industry average market multiple. The
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Chapter 13
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firms historical average market-to-book ratio, for example, may be an appropriate fit
for the firm today, but only if the firms fundamental characteristics today match
those of the firms past. In the same vein, an industry average price-earnings multiple may be an appropriate yardstick for valuing a particular firm, but only if that firm
matches the industry average fundamental characteristics. If the firm is different
today than it was in the past, or if the firm does not match the industry average, then
market multiples must be adjusted to reflect the firms fundamental characteristics.
This chapter continues to emphasize the distinction between value and price. The
chapter focuses attention on how to compute value-based multiples that reflect the
firms fundamentals and that can be compared to market price-based multiples. This
focus also directs our attention to the factors that drive multiples, so that the analyst
can avoid being ad hoc and can correctly adjust historical or industry average multiples to reflect appropriately the firms expected profitability, growth, and risk.
MARKET-TO-BOOK AND VALUE-TO-BOOK RATIOS1
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The market-to-book ratio (MB) can be computed by dividing the firms market
value of common equity at a point in time by the book value of common shareholders equity from the firms most recent balance sheet. For example, at the end of Year
11, PepsiCos market value was $86,131.8 million (= $49.05 per share 1,756 million
shares), and PepsiCos Year 11 book value of common shareholders equity was
$8,648.0 million (Appendix A). Thus, PepsiCo was trading at an MB ratio equal to
9.96 (=$86,131.8 million/$8,648.0 million). The MB ratio measures market value as
a multiple of accounting book value at a point in time. The MB ratio reflects market
value but it does not tell us what the ratio should be, given our estimate of value.
A THEORETICAL MODEL OF THE VALUE-TO-BOOK RATIO
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To compute a ratio that reflects our expectation of the firms intrinsic value to book
value, we need to compute the value-to-book ratio (VB)the value of common shareholders equity divided by the book value of common shareholders equity. The VB
ratio can be derived directly from the residual income model developed in Chapter 12.
In fact, the VB ratio model is simply a version of the residual income model that is
scaled by book value of common shareholders equity. The numerator of the VB ratio
is the estimated value of common equity, which takes into account the book value of
common shareholders equity, expected future profitability, growth, risk, and the time
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As we noted in Chapter 12, credit for the rigorous development of the residual income model, and its
extension to the value-to-book ratio model, goes to James Ohlson in: J. A. Ohlson, A Synthesis of Security
Valuation Theory and the Role of Dividends, Cash Flows, and Earnings, Contemporary Accounting
Research (Spring 1990), pp. 648676; J. A. Ohlson, Earnings, Book Values, and Dividends in Equity
Valuation, Contemporary Accounting Research (Spring 1995), pp. 661687; G. A. Feltham and J. A.
Ohlson, Valuation and Clean Surplus Accounting for Operating and Financial Activities, Contemporary
Accounting Research (Spring 1995), pp. 216230. The ideas underlying the value-to-book ratio also trace
to early work by G.A.D. Preinreich, Annual Survey of Economic Theory: The Theory of Depreciation,
Econometrica (1938), pp. 219241 and E. Edwards and P. W. Bell, The Theory and Measurement of Business
Income (Berkeley, CA: University of California Press), 1961.
Market-to-Book and Value-to-Book Ratios
[ROCEt RE ]
t =1
(1 + RE )t
BVt 1
BV0
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V0
=1+
BV0
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value of money. The VB ratio can be compared to the market-to-book ratio to identify
whether the stock is correctly priced in the market. The VB ratio of one firm can also
be used to estimate the value of a different but comparable firm, provided the analyst
makes the appropriate and necessary adjustments to the VB ratio so that it matches the
comparable firms fundamental characteristics. This section explores the theoretical
and empirical relation between estimated value, book value, and market value.
Using the same notation from prior chapters, we can compute the VB ratio with
the following model:
t =1
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In short, the VB ratio should be equal to one, plus the present value of expected future
abnormal return on common equity (the [ROCE t R E] term above) times cumulative
growth in book value (the BVt1 /BV0 term above). The growth in book value indicates
the increase in net assets on which firms can earn abnormal earnings. The growth in
book value depends on ROCE, dividend policy, and changes in common stock.
To show how we derive this model, recall from Chapter 12 the following expression for the residual income valuation model:
V0 = BV0 +
NI t (RE BVt 1 )
(1 + RE )t
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Under the residual income valuation model, the value of common shareholders
equity is equal to the book value of common equity plus the present value of all
expected future residual income, which is the amount by which expected future earnings exceed required earnings, for the remaining life of the firm.2 We compute the
required earnings (or normal earnings) of the firm in year t as the product of the
required rate of return on common equity capital times the book value of common
equity at the beginning of year t (RE BVt1). Required earnings captures the amount
of net income the firm must generate in order to provide a return to common equity
capital that is equal to the cost of common equity capital. We measure residual
income (or abnormal earnings) by the subtraction term, NIt (RE BVt1). Residual
income is the difference between expected net income and required earnings of the
firm in year t. Residual income measures the amount of wealth that the analyst
expects the firm to create (or destroy) in year t for common equity shareholders
above (or below) the cost of equity capital.
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Chapter 12 describes that the residual income valuation model depends on clean surplus accounting for
book value of common shareholders equity, which requires that expected future earnings forecasts are
comprehensive measures of income for the firms common equity shareholders, and that expected future
dividends reflect all capital transactions between the firm and common equity shareholders. Throughout
this chapter, when we refer to expected future earnings or net income in the context of residual
income valuation, we mean expected future comprehensive income available for common shareholders.
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Chapter 13
t =1
NI t
BVt 1
RE
BV0
BV0
(1 + RE ) t
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V0
BV0
=
+
BV0 BV0
To convert the residual income model into a model for the VB ratio, we scale both
sides of the equation by BV0, which produces the following equation:
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We rewrite BV0 divided by BV0 as equal to one. We rewrite the NIt/BV0 term as
follows:
NI t
NI t
BV
BVt 1
=
t 1 = ROCEt
BV0 BVt 1 BV0
BV0
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To rewrite NIt/BV0 this way, we state ROCEt = NIt /BVt1. Note that this computation
of ROCEt divides net income in period t by book value of common equity at the
beginning of period t. This ROCE computation differs slightly from the approach in
Chapter 4 in which we compute ROCE as net income divided by the average book
value of equity during period t.3 Also, note that BVt1/BV0 is the cumulative growth
factor in book value of common equity between year 0 (the date of the valuation)
and period t 1. As indicated above, growth in book value is a function of the earnings generated each period plus additional capital contributions by shareholders, less
equity capital paid out to shareholders through dividends and stock buybacks. The
growth in book value indicates growth in net assets invested, on which a firm can
earn abnormal returns.
By decomposing the term NIt /BV0 into these two parts, we can restate NIt/BV0 as
the product of ROCE in year t times the cumulative growth in book value from year
0 to the start of year t. Return on common equity is a function of profitability on
beginning of year common equity; beginning of year common equity is a function
of cumulative growth. We can substitute these two components of NIt /BV0 into the
VB equation, as follows:
V0
=1+
BV0
t =1
BVt 1
BVt 1
ROCEt BV RE BV
0
0
t
(1 + RE )
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Now both terms in the numerator of the summation term are multiplied by the same
cumulative book value growth factor. We rearrange that equation as follows:
Theoretical and empirical research on the VB ratio typically defines ROCE as net income to common
shareholders for a year divided by common shareholders equity at the beginning of the year. In contrast,
we have used average common shareholders equity in the denominator of ROCE throughout this book.
The theoretical development and application of the VB model in this section uses shareholders equity at
the beginning of the year, although the bias in using average shareholders equity should not be particularly significant.
t =1
[ROCEt RE ]
(1 + RE )t
BVt 1
BV0
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We now have a useful model for the value-to-book ratio. Next we consider each term.
First, as a starting point, the VB ratio will equal one, to reflect the book value of
common equity invested in the firm. The summation term indicates how the VB
ratio should differ from one as a function of the firms expected future abnormal
profitability (the ROCE t RE term) times the firms cumulative growth in book value
(the BVt1 /BV0 term), all of which is discounted to present value, reflecting the firms
cost of equity capital (RE) and the time value of money. Thus, the residual income
model specifies the firms VB ratio as a function of the firms value drivers: capital in
place, profitability, cost of equity capital, growth, and time value of money. The VB
model provides a valuation approach in which all of the inputs to valuation can be
expressed as forecasts of ratesexpected future ROCE, RE, and growth. The only dollar amount the analyst needs in order to use the VB ratio to compute the dollar value
of common shareholders equity is the book value of common shareholders equity,
which is observable from the shareholders equity section of the balance sheet.
The expression for the VB ratio provides some insights into valuation:
Economics teaches that, in equilibrium, firms will earn a return equal to the cost
of capital (that is, ROCE = RE). The VB model indicates that a firm in steadystate equilibrium earning ROCE = RE will maintain (not create or destroy)
shareholder wealth and will be valued at book value (that is, VB = 1).
A firms value should be greater than its book value of common equity insofar
as the firm will generate wealth for common equity shareholders by earning
a return (ROCE) that exceeds the cost of capital (RE). That is, VB > 1 if
ROCE > RE. Firms that earn a return that is less than the cost of equity capital
(that is, ROCE < RE) will destroy shareholder wealth and will be valued below
book value (that is, VB < 1).
Growth is not value-adding in itself. Growth adds value to shareholders only if
the growth is abnormally profitable. If expected ROCE equals RE on new projects (that is, zero NPV projects), then these new projects will not create (or
destroy) common shareholders equity value. New projects will be abnormally
profitable only when their expected ROCE exceeds RE.
The risk of the firm increases the equity cost of capital. Increasing the equity cost
of capital reduces firm value in two ways: (1) by increasing the required ROCE
the firm must earn to cover the increased cost of capital RE (that is, the hurdle
rate goes up); and (2) by increasing the discount rate used to compute the present value of residual income.
If a firms VB ratio differs from the industry average VB ratio, it should be
because the firms expected future ROCE, RE, or book value growth differ from
the industry averages. If a firms VB ratio changes over time, it should be because
current expectations for the firms future ROCE, RE, or book value growth differ
from the past expectations for the firms future ROCE, RE, or book value growth.
V0
=1+
BV0
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Chapter 13
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Example 1. Suppose an analyst is evaluating a firm with $1,000 of book value of

common equity and a cost of equity capital equal to 10 percent. Assume that the analyst forecasts that the firm will earn ROCE of 15 percent until Year +3, but then after
Year +3 the firm will earn ROCE equal to 10 percent. The analyst also expects the
firm will reinvest all net income (that is, pay zero dividends), and it will not issue or
buy back stock. Using the VB ratio approach, the analyst should assign the firm a VB
ratio equal to one plus the present value of future residual ROCE times growth. The
present value of future residual ROCE times growth is determined as follows:
+1
+2
+3
+4
0.15
0.15
0.15
0.10
0.05
0.05
0.05
0.00
1.00 = (1.15)
1.15 = (1.15)1
1.3225 = (1.15)2
1.52088 = (1.15)3
0.05000
0.05750
0.06613
0.00000
0.9091
0.8264
0.7513
0.6830
0.04545
0.04752
0.04968
0.00000
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PV Factor
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Expected
ROCE
Cumulative
Book Value
Growth Factor
to Year t1
PV of
Residual
ROCE
times
Cumulative
Growth
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Year
Residual
ROCE
= ROCE RE
Residual
ROCE
times
Cumulative
Growth
The sum of the present values of residual ROCE times cumulative growth through
Year +3 equals 0.14265, and the sum in all years after Year +3 is zero. The VB ratio of
this firm is therefore 1.14265. We can multiply the VB ratio by book value of equity
to determine that firm value is $1,142.65 (= 1.14265 VB ratio $1,000 book value
equity). Note that we have determined this VB ratio with all of the inputs expressed
in rates. We can confirm this value using dollar amounts and the residual income
model approach from Chapter 12, as follows:
+2
+4
so
Required
Income
= BVt 1 RE
Residual
Income
PV
Factor
PV of
Residual
Income
0.15
$150.00
= 0.15 1,000
$1,000
$100
= 1,000 0.10
$50.00
= 150 100
0.9091
$45.45
0.15
$172.50
= 0.15 1,150
$1,150
= 1,000 + 150
$115
= 1,150 0.10
$57.50
= 172.50 115
0.8264
$47.52
0.15
$198.38
= 0.15 1,322.5
$1,322.5
= 1,150 + 172.50
$132.25
= 1,322.5 0.10
$66.13
= 198.38 132.25
0.7513
$49.68
$0.00
= 152.09 152.09
0.6830
$ 0.00
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+3
Expected
Earnings
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Expected
Year ROCE
+1
Cumulative Book
Value at the end
of Year t 1
(BVt 1)
0.10
$152.09
= 0.10 1,520.88
$1,520.88
$152.09
= 1,322.50 + 198.38 = 1,520.88 0.10
The sum of the present values of residual income through Year +3 equals $142.65,
the sum in all years after Year +3 is zero, and book value of equity is $1,000, so the
residual income model confirms that firm value is $1,142.65.
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We described above a number of economic reasons why VB and MB ratios may

differ from one. For example, the firm may have competitive advantages that enable
it to earn an ROCE that is greater than RE. To the extent that the firm can create and
sustain these competitive advantages, the firm will increase the magnitude and persistence over time of the degree to which ROCE exceeds RE, thereby increasing the VB
and MB ratios. In addition, to the extent the firm will generate future growth by
investing in abnormally profitable projects, the VB and MB ratios will differ from
one.
A firms VB and MB ratio may differ from one for accounting reasons in addition to
economic reasons.4 The firm may have investments in projects for which accounting
methods and principles cause ROCE to differ from RE. For example, firms may make
substantial investments in successful research and development projects, brand equity,
or human capital. If these investments were internally generated through research and
development activities, marketing and advertising activities, or human capital recruiting and training activities, and if the investments in these activities were expensed
according to conservative accounting principles (as is common under GAAP in the
United States and most countries), then the firm will have substantial off-balance sheet
assets and off-balance sheet common shareholders equity. These off-balance sheet
assets generate net income, but common shareholders equity is understated, so ROCE
will be relatively high. These effects can be observed among certain firms in many different industries, such as pharmaceuticals, biotechnology, software, and consumer
goods.
In the case of PepsiCo and Coca-Cola, for example, these firms have created substantial off-balance sheet brand equity over many years of successful product development, advertising, and brand-building activities, and the investments in these
activities have been expensed. Thus, for these firms, the book value of common
shareholders equity does not recognize the off-balance sheet value of brand equity.
Relative to RE, ROCE for PepsiCo and Coca-Cola is very high and likely will continue
to be very high for many years in the future.
Over a sufficiently long period of time, however, the impact of accounting principles on the VB and MB ratio will diminish because economics teaches us to expect
that competitive equilibrium forces will drive ROCE to converge to RE in the long
run. Also, the self-correcting nature of accounting will eventually eliminate biases in
ROCE and book value of equity. For example, consider a biotechnology company
that invests for several years in research and development to develop a particular
drug. During the initial years of research, the firm incurs research costs that GAAP
REASONS WHY VB RATIOS AND MB RATIOS MAY DIFFER

FROM ONE
Stephen Ryan found that book value changes lag market value changes in part because of GAAPs use of
historical cost valuations for assets. The lag varies in part based on the degree of capital intensity of firms.
See Stephen Ryan, A Model of Accrual Measurement and Implications for the Evolution of the Book-toMarket Ratio, Journal of Accounting Research (Spring 1995), pp. 95112.
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Chapter 13
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requires the firm to expense. Its ROCE and book value of equity will be low during these years. After developing and then marketing the final drug, ROCE will
be high because the firm generates revenues without offsetting research costs. The
high ROCE will increase retained earnings, and, over time, the initial conservative
biases in ROCE and book value will be corrected.
EMPIRICAL DATA ON MB RATIOS
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Exhibit 13.3 presents descriptive statistics for MB ratios across 36 industries during the decade from 1991 to 2000.5 The descriptive statistics include the 25th percentile, median, and 75th percentile MB ratios for the sample as a whole and for each
industry, listed in ascending order of the median MB ratio. The median MB ratio for
the 64,297 firm-years in this sample is 1.85. These data reveal substantial variation in
MB ratios across industries and within industries during this period.
The differences in industry median MB ratios in Exhibit 13.3 likely relate in part
to differences in competitive conditions driving differences in growth and ROCE
relative to RE, as well as differences in alternative accounting principles. Economically,
in an industry that can be characterized as mature and competitive, the median
firm will likely generate ROCE that is close to RE and will not likely generate unusually
high rates of growth. Such firms tend to have median MB ratios closer to one. For
example, firms in mature competitive industries such as textiles, real estate, insurance,
banking, metals, and metal products tend to have MB ratios that are lower than the
sample average.
With respect to accounting, the assets of firms in some of these industries
particularly banks and insurersare primarily investments in financial assets, some
of which appear on the balance sheet at fair value, and thus MB ratios are closer to
one. In contrast, some of the industries with relatively high MB ratios are more likely
to have off-balance sheet assets and shareholders equity. For example, the chemical
industry includes pharmaceutical firms, which expense research and development
expenditures in the year incurred. The health services, personal services, and business
services industries expense compensation costs in the year incurred and do not capitalize the value of their employees on the balance sheet. The balance sheet understates the economic value of key resources in each of these industries. These
industries have MB ratios considerably in excess of one.
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EMPIRICAL RESEARCH RESULTS ON THE PREDICTIVE POWER

OF MB RATIOS
Several empirical studies have found that MB ratios are fairly stable, mean reverting slowly over time, and that MB ratios are reliable predictors of future growth in
book value and expected future ROCE (implying that ROCE also mean reverts
To compute these descriptive statistics on market-to-book value ratios, we deleted firm-years with negative book value of equity. We also deleted firm-year observations in the top 1 percent of the distribution
as potential outliers with undue influence on the descriptive statistics.
EXHIBIT 13.3
Descriptive Statistics on Market-to-Book Ratios, 19912000
Median
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75th Percentile
1.13
1.85
3.34
0.78
0.73
0.94
0.98
0.89
0.96
0.80
0.83
0.90
1.06
1.32
1.17
1.02
1.09
0.97
1.09
1.05
1.04
1.15
1.28
1.14
1.21
1.11
1.14
0.90
1.25
1.23
1.25
1.30
1.45
1.37
1.40
1.84
1.61
1.96
2.87
1.28
1.31
1.33
1.34
1.45
1.47
1.48
1.49
1.55
1.61
1.62
1.64
1.68
1.69
1.70
1.74
1.76
1.81
1.82
1.83
1.84
1.90
1.91
1.95
2.02
2.08
2.15
2.21
2.21
2.34
2.39
2.41
2.93
3.06
3.34
4.20
2.00
2.50
1.93
1.82
2.31
2.27
2.44
3.01
2.77
2.43
2.00
2.58
3.11
3.28
3.05
2.84
3.02
3.02
3.10
2.55
3.16
2.93
3.42
3.50
2.85
3.67
3.75
3.85
3.83
3.69
4.46
3.74
5.51
5.82
5.96
11.63
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25th Percentile
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Full Sample* on Compustat

(N = 64,297 firm-years) . . . . . . . . . . . . . . . . . . . . . .
Industry:
Textiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Real Estate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Depository Institutions . . . . . . . . . . . . . . . . . . . . . .
Metals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Metal Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Hotels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
RetailersGeneral Merchandise . . . . . . . . . . . . . . .
WholesaleDurables . . . . . . . . . . . . . . . . . . . . . . . .
Lumber . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Paper . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Motion Pictures . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Security Brokers . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Metal Mining . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Oil and Gas Extraction . . . . . . . . . . . . . . . . . . . . . . .
Grocery Stores. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Restaurants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Transportation by Air . . . . . . . . . . . . . . . . . . . . . . . .
Petroleum and Coal . . . . . . . . . . . . . . . . . . . . . . . . .
WholesaleNondurables. . . . . . . . . . . . . . . . . . . . .
Transportation Equipment. . . . . . . . . . . . . . . . . . . .
Amusements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
RetailingApparel . . . . . . . . . . . . . . . . . . . . . . . . . .
Forestry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Industrial Machinery and Equipment . . . . . . . . . . .
Food Processors . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Electronic and Electric Equipment . . . . . . . . . . . . .
Health Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Personal Services. . . . . . . . . . . . . . . . . . . . . . . . . . . .
Instruments and Related Products . . . . . . . . . . . . . .
Printing and Publishing . . . . . . . . . . . . . . . . . . . . . .
Communication . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Business Services. . . . . . . . . . . . . . . . . . . . . . . . . . . .
Chemicals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Tobacco . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
923
*To compute these descriptive statistics on market-to-book value ratios, we deleted firm-years with negative book value of equity. We also deleted firmyear observations in the top 1 percent of the distribution as potential outliers with undue influence on the descriptive statistics.
924
Chapter 13
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slowly).6 For example, Victor Bernard grouped roughly 1,900 firms into 10 portfolios
each year between 1972 and 1981 based on their MB ratios. He then computed the
mean ROCE for each portfolio in the formation year and for each of the ten subsequent years. Exhibit 13.4 summarizes a portion of Bernards results, grouping firms
in the lowest 3 MB portfolios, middle 4 MB portfolios, and highest 3 MB portfolios.7
The data in Exhibit 13.4 indicate that firms with the highest MB ratios tend to
have the highest ROCEs through Year +10, and firms with the lowest MB ratios tend
to have the lowest ROCEs through Year +10. The results from the Bernard study also
indicate that firms with the highest MB ratios have the highest growth rates in book
value of equity through Year +10, and firms with the lowest MB ratios have the lowest growth rates through Year +10. The results in the Bernard study also indicate
(although it is not apparent from the summary of results in Exhibit 13.4) that the
predictive power of MB ratios for future ROCEs does tend to diminish as the horizon lengthens. In Year +10, for example, there is relatively little difference in ROCEs
across firms in the 3rd through 9th MB portfolios, as these firms experience ROCEs
that tend to converge to 14 percent. These results are consistent with the steady mean
so
Low
Medium
High
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Low
Medium
High
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Mean MB Ratio
0.67
1.15
2.65
0.11
0.11
0.10
MB Portfolio
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EXHIBIT 13.4
The Relation between MB Ratios and Future ROCE and
Future Book Value Growth
Median ROCE for Year:
+1
+5
0.09
0.13
0.17
0.12
0.14
0.16
+10
0.12
0.14
0.20
Cumulative Percent Increase in

Book Value through Year:
0.67
1.15
2.65
+1
+5
+10
0%
0%
0%
15%
15%
21%
54%
69%
139%
190%
204%
394%
Victor L. Bernard, Accounting-Based Valuation Methods, Determinants of Market-to-Book Ratios and

Implications for Financial Statement Analysis, Working Paper, University of Michigan, 1993; Jane A. Ou
and Stephen H. Penman, Financial Statement Analysis and the Evaluation of Market-to-Book Ratios,
Working Paper, Columbia University, 1995; Stephen H. Penman, The Articulation of Price-Earnings
Ratios and Market-to-Book Ratios and the Evaluation of Growth, Journal of Accounting Research, Vol. 34,
No. 2 Autumn 1996, pp. 235259; William H. Beaver and Stephen G. Ryan, Biases and Lags in Book Value
and Their Effects on the Ability of the Book-to-Market Ratio to Predict Book Return on Equity, Journal
of Accounting Research, Vol. 38, No. 1 (Spring 2000), pp. 127149.
7
To reduce the effects of survivorship bias, Bernard included firms that did not survive the entire 10-year
future horizon, and included any gain or loss on the cessation of the firm (from bankruptcy, takeover, or
liquidation) in the final year ROCE.
Application of the Value-to-Book Model to PepsiCo
reversion in ROCEs over time, consistent with movement toward competitive

equilibrium.
925
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APPLICATION OF THE VALUE-TO-BOOK MODEL TO

PEPSICO
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In Chapter 12, we estimated PepsiCos share value at the end of Year 11 to be

roughly $69, based on the pro forma financial statement forecasts developed in
Chapter 10 and the residual income model valuation. We next illustrate the valuation
of PepsiCo shares using the value-to-book model, implementing the same forecasts
developed in Chapter 10, the same equity cost of capital (8.0 percent), and the same
long-run growth rate (5.0 percent). We also demonstrate the forecasts and valuation
estimates in the FSAP Forecasts and Valuation spreadsheets in Appendix D.
To proceed with the VB model, we will follow seven steps:
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(1) estimate the expected ROCE each period, computed as NIt /BVt1;
(2) compute expected residual ROCE each period by subtracting the equity cost
of capital from expected ROCE;
(3) determine the cumulative growth factor in book value of common shareholders equity to the beginning of each period (computed as BVt1/BV0);
(4) multiply the expected residual ROCE by the cumulative growth factor;
(5) discount the expected residual ROCE with growth to present value, including
continuing value;
(6) compute the implied VB ratio by adding one (the ratio of book value over
book value) to the sum of the present value of the expected residual ROCE
with growth;
(7) compare the implied VB ratio to the MB ratio to determine whether market
price is greater than, equal to, or less than our estimate of value. Equivalently,
we can multiply the implied VB ratio by book value of equity to determine the
value of common shareholders equity, and then divide by the number of
shares outstanding to convert this total to a per-share estimate of value for
PepsiCo, which we then compare to market price.
Th
We next illustrate each of these seven steps with PepsiCo. The Year +1 projected ROCE
is 38.9 percent, computed as net income available for common shareholders in Year +1
divided by book value of common equity at the start of Year +1 (= $3,367.3 million/$8,648.0 million). The residual ROCE is 30.9 percent after subtracting 8.0 percent
for the cost of equity capital. The cumulative growth in book value (BVt1/BV0) in Year
+1 is 1.0, because Year +1 is the first year of the valuation horizon.8 The product of Year
+1 residual ROCE and cumulative growth is 30.9 percent, which we discount to present value using an 8.0 percent cost of equity capital. Exhibit 13.5 presents these
8
We project PepsiCos book value of common equity will grow to $9,466.2 million during Year +1.
Therefore the cumulative growth factor in book value of common equity as of the start of Year +2 will be
1.095 (= $9,466.2 million/$8,648.0 million).
Chapter 13
EXHIBIT 13.5
Valuation of PepsiCo:
Present Value of Residual ROCE in Year +1 through Year +10
1
0.309
0.926
0.286
2.846
Year +3
$3,656.4
$9,466.2
0.386
0.306
$ 3,975.8
$10,364.7
0.384
0.304
1.095
0.335
0.857
0.287
1.199
0.364
0.794
0.289
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$3,367.3
$8,648.0
0.389
0.309
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COMPREHENSIVE INCOME AVAILABLE FOR

COMMON SHAREHOLDERS . . . . . . . . . . . . . . . . . . . . . . . . .
Common Shareholders Equity (at beginning of year) . . . . . . . . .
Implied ROCE (Comp Inc./Begin. Common Equity). . . . . . . . . .
Residual ROCE (assuming RE = 0.08) . . . . . . . . . . . . . . . . . . . . . .
Cumulative Book Value Growth Factor as of the
Beginning of Year. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Residual ROCE times Cumulative Book Value Growth Factor . . .
Present Value Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
PV Residual ROCE times Growth . . . . . . . . . . . . . . . . . . . . . . . . .
Sum of PV Residual ROCE in Year +1 through Year +10 . . . . . . .
Year +2
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Year +1
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computations for PepsiCo for Year +1 through Year +10. The sum of the present value
of residual ROCE times growth in Year +1 through Year +10 is 2.846.9
We use the same steps to compute the Year +11 residual ROCE for purposes of
computing continuing value. As described in the previous chapter, we project net
income in Year +11 to grow by the 5.0 percent long-run growth rate. We compute
book value as of the start of Year +11 (the end of Year +10), compute implied residual
ROCE, and multiply by the cumulative growth factor in book value up to the beginning of Year +11. The projected ROCE11 is 36.3 percent (= NI11 /BV10 = $6,920.0
million/$19,073.7 million). The projected residual ROCE11 is therefore 28.3 percent.
Cumulative growth in book value from Year 0 to the beginning of Year +11 (the end
of Year +10) is 2.206 (= BV10 /BV0 = $19,073.7 million/$8,648.0 million). We therefore project in Year +11 the product of residual ROCE times cumulative growth is
62.4 percent (= 28.3 percent 2.206).
We use the Year +11 residual ROCE with growth (62.4 percent) in the continuing
value computation, as follows (allowing for rounding):
ContinuingValue 0 = [(NI 10 (1 + g )/ BV10 ) RE ] [BV10 / BV0 ] [1 / (RE g )] [1 / (1 + RE )10 ]

= [($6, 590.4 1.05 / $19, 073.7) 0.08] [$19, 073.7 / $8, 648.0] [1 / (0.08 0.05)] [1 / (1 + 0.08)10 ]
= 0.283 2.206 33.33 0.463
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= 9.630
9
This value should be interpreted as a component of the VB ratio, because all of the computations in the
model are scaled by BV0. Thus, the amount 2.846 can be interpreted as an estimate that PepsiCo will create residual income in Years +1 through +10 that, in present value, is equal to 2.846 times the current
book value of common equity. To reconcile this computation with the residual income model computations in Chapter 12, recognize that 2.846 times book value of $8,648.0 million equals $24,613.0 (allow for
rounding), which is the present value of residual income through Year +10 computed in Exhibit 12.2.
Application of the Value-to-Book Model to PepsiCo
EXHIBIT 13.5
Exhibit 13.5continued
927
Year +5
Year +6
Year +7
Year +8
Year +9
$ 4,312.3
$11,572.9
0.373
0.293
$ 4,649.6
$12,149.2
0.383
0.303
$ 4,991.0
$13,380.8
0.373
0.293
$ 5,350.0
$14,366.6
0.372
0.292
$ 5,734.9
$15,423.7
0.372
0.292
$ 6,147.5
$16,556.8
0.371
0.291
$ 6,590.4
$17,771.4
0.371
0.291
1.338
0.392
0.735
0.288
1.405
0.425
0.681
0.289
1.547
0.453
0.630
0.286
1.661
0.486
0.583
0.283
1.783
0.520
0.540
0.281
1.915
0.558
0.500
0.279
2.055
0.598
0.463
0.277
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The total present value of PepsiCos expected residual ROCE with growth,
expressed as components of the VB ratio, is the sum of these two parts:
2.846
9.630
12.476
Present Value of Residual ROCE in Year +1 through Year +10 . . . . . . . . . .

Present Value of Continuing Value of ROCE in Year +11 and beyond . . . .
Present Value of Residual ROCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
so
Necessary Adjustments to Compute the Value-to-Book Ratio
om
To compute the VB ratio for common equity, we need to add PepsiCos beginning
book value of common equity expressed as a ratio of beginning book value of equity,
which is, of course, equal to one. As described in Chapters 11 and 12, our present
value calculations overdiscount because they discount each years residual ROCE for
full periods when, in fact, the firm generates residual ROCE throughout each period
and we should discount from the midpoint of each year to the present. Therefore, to
make the correction, we multiply the present value sum by the mid-year adjustment
factor [1 + (RE/2) = 1 + (0.080/2) = 1.040]. Making these two adjustments produces
the implied VB ratio as follows:
Th
Present Value of Residual ROCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Add: Beginning Book Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Multiply by the Mid-Year Correction Factor . . . . . . . . . . . . . . . . . . . . .
Implied VB Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Year +10
ng
Year +4
12.476
+ 1.000
13.476
1.040
14.015
928
Chapter 13
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These computations suggest that PepsiCo common equity should be valued at 14.015
times the book value of equity at the start of the valuation horizon, which is the end
of Year 11. At that time, PepsiCos market value was $86,131.8 million (= $49.05 per
share 1,756 million shares). Thus, PepsiCo was trading at an MB ratio equal to 9.96
(= $86,131.8 million/$8,648.0 million). The VB ratio is 41 percent greater than the
MB ratio, implying PepsiCo shares were underpriced by 41 percent at that time.
Equivalently, we can convert the VB ratio into a share value estimate for purposes
of comparing to price. If we multiply book value equity by the VB ratio, we obtain
the value estimate of PepsiCo common equity of $121,205.9 million (= $8,648.0 million 14.015 VB ratio; allow for rounding). Dividing by 1,756 million shares outstanding indicates that PepsiCos common equity shares have a value of $69.02 per
share, a value estimate that is identical to the value estimates we obtained from the
residual income and dividend models in Chapter 12 and the free cash flows to common equity shareholders model in Chapter 11. The computations to arrive at
PepsiCos common equity share value are summarized in Exhibit 13.6.
We can conduct a sensitivity analysis for the estimate of PepsiCos VB ratio to
assess a reasonable range of VB ratios for PepsiCo. We will find that the sensitivity of
the VB ratio estimate is identical to the sensitivity of the residual income model value
estimates demonstrated in Chapter 12. This is to be expected because both models
use the same forecasts and valuation assumptions. The VB model is simply a scaled
version of the residual income model.
EXHIBIT 13.6
Valuation of PepsiCo using the Residual ROCE Valuation Model
Valuation Steps
so
Sum of PV Residual ROCE in Year +1

through Year +10
Add Continuing Value in Present Value
om
Total PV Residual ROCE

Add: Beginning Book Value of Equity Ratio
Th
Adjust to Midyear
Value-to-Book Ratio of Common Equity
Book Value of Common Equity
Value of Common Equity
Shares Outstanding
Estimated Value per Share
Current Price per Share
Percent Difference
Computations
Amounts
See Exhibit 13.5.
2.846
Year +11 residual ROCE assumed to

grow at 5.0%; discounted at 8.0%.
Computations in FSAP.
9.630
Beginning Book Value of Equity from

Year 11 Balance Sheet.
Multiply by 1 + (RE/2)
(Positive number indicates

underpricing.)
=
12.476
+
1.000
=
13.476
1.040
=
14.015
$ 8,648.0
=$121,205.9
1,756.0
=$
69.02
$
49.05
41%
Price-Earnings and Value-Earnings Ratios
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As we noted in Chapter 12, the capital markets devote enormous amounts of time
and energy to forecasting and analyzing firms earnings numbers. It is, therefore, no
surprise that the market multiple that receives most frequent use and attention is the
price-earnings (PE) ratio. Analysts reports and the financial press make frequent references to PE ratios. The Wall Street Journal reports PE ratios as part of the daily coverage of stock prices and trading. The capital markets increasingly evaluate ratios
that integrate the PE ratio with expected future earnings growth, to capture explicitly the links between price, earnings, and growth.
This section first describes the theoretical model for computing value-earnings
ratios. The section then describes computing and using PE ratios from a practical perspective because of the widespread use of PE ratios in practice. We then discuss the
strict assumptions implied by PE ratios, and describe the conditions in which PE ratios
may not capture appropriately the theoretical relation between value and earnings for
most firms and the difficulties one encounters in reconciling actual PE ratios with those
indicated by the theoretical value-earnings model. In this section, we also incorporate
the role of earnings growth and examine price-earnings-growth (PEG) ratios. We
conclude the section by describing empirical data on PE ratios, the predictive power of
PE ratios, and the empirical evidence on the articulation between PE ratios and MB
ratios.
PRICE-EARNINGS AND VALUE-EARNINGS RATIOS
A THEORETICAL MODEL FOR THE VALUE-EARNINGS RATIO
Th
om
so
The VE ratio is the ratio of the value of common shareholders equity divided by
earnings for a single period. The previous chapter described how to determine common equity value as a function of present value of expected future earnings and the
residual income model. In the residual income model, we use clean surplus accounting and measure future earnings as expected future comprehensive income (that is,
income that includes all of the income to common shareholders). Thus, in theory, the
analyst should measure the VE ratio as the value of common equity divided by next
periods expected comprehensive income. This way, the VE ratio achieves consistent
alignment of perspective (numerator and denominator both forward-looking) and
measurement (numerator and denominator both based on income measurement
that is comprehensive).
If one has already computed firm value using the forecasting and valuation models developed in the last three chapters, then computing the VE ratio is a simple matter of division. For example, in prior chapters we estimated PepsiCos common
shareholders equity value to be $121,205.9 million at the end of Year 11. We also projected Year +1 comprehensive income will equal net income available for common
shareholders, which will equal $3,367.3 million. Thus, we can compute the VE ratio
for PepsiCo at the end of Year 11 as:
V0/E1 = $121,205.9 million/$3,367.3 million = 36.0
930
Chapter 13
Or equivalently, on a per-share basis as:
Vps 0 /Eps1 = ($121,205.9 million/1,756 million shares)/($3,367.3 million/

1,756 million shares) = $69.02/$1.92 = 36.0
ng
We can also derive the VE ratio from the VB ratio determined using the residual
income model in the previous section. We can employ an algebraic step to derive the
firms VE ratio from the firms VB ratio, as follows:
ni
V0/E1 = V0/BV0 BV0/E1 = V0/BV0 (1/ROCE1)
Using this approach, we can derive PepsiCos VE ratio from the VB ratio we computed in the previous section, as follows:
Le
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V0/E1 = V0/BV0 BV0/E1 = V0/BV0 (1/ROCE1)

= ($121,205.9 million/$8,648.0 million) ($8,648.0 million/$3,367.3 million)
= 14.015 2.5682
= 14.015 (1/0.389)
= 36.0
Th
om
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Thus, we compute that PepsiCos VE ratio should equal 36.0. We convert PepsiCos
VB ratio of 14.015 into the VE ratio by multiplying by 1/ROCE1, which we project
will be the inverse of 38.9 percent.
Notice that we simply derived the VE ratio from the computation that PepsiCos
value is equal to $121,205.9 million, which is based on specific forecasts of PepsiCos
future earnings. Obviously, using value to compute a VE ratio will not provide any
new information about PepsiCos value. So what is the point of computing a VE
ratio?
The VE ratio provides the theoretically correct benchmark to evaluate the firms
PE ratio. We can compare PepsiCos VE ratio of 36.0 to PepsiCos PE ratio to assess
the market value of PepsiCo shares. This comparison is equivalent to comparing V to
P (that is, value to price). With the theoretically correct VE ratio, we can also project
VE ratios for other firms, including making adjustments as necessary to capture the
other firms fundamental characteristics of profitability, growth, and risk. In addition, with the theoretically correct VE ratio, we have a benchmark to gauge other
firms PE ratios in order to assess whether the market is under- or overpricing their
shares. In the next section, we discuss the practical advantages and disadvantages in
using PE ratios as shortcut valuation metrics.
PRICE-EARNINGS RATIOS
As a practical matter, analysts, the financial press, and financial databases commonly measure PE ratios as current period share price divided by reported earnings
per share for either the most recent prior fiscal year or the most recent four quarters
10
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(sometimes referred to as the trailing-twelve-months earnings).10 The Wall Street

Journal and financial data web sites such as Yahoo! Finance commonly compute
PE ratios this way. With this approach, we compute the PE ratio for PepsiCo as of
the end of Year 11 as follows: Price per share11/Earnings per share11 = $49.05/$1.51 =
32.5. Thus, at the end of Year 11, PepsiCo shares traded at a multiple of 32.5 times
Year 11 earnings per share.11
The common approach to compute the PE ratio by dividing market price by earnings per share for the most recent year is practical because analysts can readily
observe price per share and historical earnings per share for most firms. However,
this common approach creates a logical misalignment for valuation purposes
because it divides share pricewhich reflects the present value of future earnings
by historical earnings. If historical earnings contain unusual or nonrecurring gains or
losses that are not expected to persist in future earnings, then the analyst should
cleanse the reported historical earnings of these effects in order to compute a PE ratio
that reflects earnings that are likely to persist in the future. Chapter 6 describes techniques to identify elements of income that are unusual and nonrecurring, adjust
reported earnings to eliminate their effects, and thereby measure recurring, persistent earnings.
As an alternative approach to create a more logical alignment of price and earnings, the analyst can compute the PE ratio by dividing share price by the analysts
forecast of future earnings per sharefor example, expected earnings per share one
year ahead. A PE ratio based on expected future earnings, however, requires the analyst to forecast future earnings (or have access to another analysts forecast). The reliability of a forward-looking PE ratio then depends on the reliability of the earnings
forecast. Earnings forecast errors will distort forward-looking PE ratios.
We compute the forward-looking PE ratio for PepsiCo as of the end of Year 11
using our forecast that Year +1 earnings will be $3,367.3 million as follows: Price per
share0/Earnings per share+1 = $49.05 per share/($3,367.3 million/1,756 million
shares) = 25.6. Thus, at the end of Year 11, PepsiCo shares traded at a multiple of 25.6
times the Year +1 earnings forecast. PepsiCos VE ratio of 36.0 is 41 percent greater
than PepsiCos PE ratio of 25.6 at the end of Year 11, consistent with our prior estimates of PepsiCos value.12
931
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In theory, to be consistent with clean surplus accounting and residual income valuation, the denominator should be based on comprehensive income per share. However, analysts, the financial press, and
financial databases rarely, if ever, compute PE ratios based on comprehensive income per share, in part
because (a) U.S. GAAP does not yet require reporting comprehensive income on a per-share basis, and
(b) the other comprehensive income items are usually unrealized gains and losses that are not likely to
be a permanent component of income each period. We follow traditional practice in this chapter and
compute PE ratios using reported earnings figures.
11
If we compute PepsiCos PE ratio using amounts in millions rather than per-share amounts, we obtain a
PE ratio of 32.4 (= $86,131.8 million/(Net Income of $2,662 million $4 million preferred dividends)).
This PE ratio is slightly lower than the PE ratio of 32.5 based on per-share amounts because PepsiCo
reports earnings per share based on the weighted average number of common shares outstanding during
the year (which is consistent with U.S. GAAP) rather than the number of shares outstanding at year-end.
12
In this case, our forecasts of net income and comprehensive income for PepsiCo in Year +1 are the same,
so the PE ratio using earnings per share is equal to that using comprehensive income per share.
932
Chapter 13
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Notice that we simply derived the PE ratio by dividing PepsiCos market share
price by either earnings per share of the past year or by our forecasts of PepsiCos
future earnings per share. Obviously, using price to compute a PE ratio will not provide any new information about PepsiCos share value. So what is the point of computing a PE ratio?
PE ratios are practical tools used by analysts interested in valuation shortcuts. In
some circumstances, analysts need to react with timely ballpark-estimates of valuation, and PE ratios provide a quick and efficient way to estimate firm value as a multiple of earnings. Analysts commonly assess benchmark PE ratios that they expect a
firm to have based on past PE ratios for that firm, or industry-average PE ratios, or
comparable firms PE ratios. Analysts use benchmarks like these to project a firms PE
ratio quickly, using one-period earnings as a common denominator for relative valuations, rather than engaging in the extensive computations necessary to determine
the correct value-earnings ratio to assess whether the market has priced the firms
shares appropriately.
Analysts also use PE ratios as potentially informative benchmarks to project
earnings-based valuation multiples that they use to compare valuations across companies or to project the valuations of other companies. For example, we could compare PepsiCos PE ratio to the PE ratios of Coca-Cola, Cadbury-Schweppes, or other
beverage companies. We might also use PepsiCos PE ratio to project valuations for
these beverage companies, or to project valuations for privately held firms or divisions of companies. Investment bankers use comparable companies PE ratios, for
example, to benchmark reasonable ranges of share prices for IPOs.
PE ratios have the advantage of speed and efficiency, but they are not necessarily
precise valuation estimates. When using PE ratios, therefore, the analyst must be careful to adjust them to match the fundamental characteristics of different companies.
For example, PepsiCos PE ratio should differ from Coca-Colas insofar as the fundamental characteristics of profitability, growth, and risk differ across these two firms.
Such differences might arise, for example, because PepsiCo derives a major portion of
earnings from the snack food business, which Coca-Cola does not have. Similarly,
Coca-Cola derives more of its earnings from international sales than PepsiCo. These
and other factors cause the profitability, growth, and risk of PepsiCo and Coca-Cola
to differ, and therefore cause their PE ratios to differ. We will describe PE ratio differences in more detail after we first describe the conceptual basis for PE ratios.
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PE Ratios Project Firm Value from Permanent Earnings

What should a firms PE ratio be? What is an appropriate valuation multiple for a
firms earnings? We have seen that, in theory, the firms PE ratio should equal the
firms VE ratio. However, if the analyst has not computed value in order to determine
the VE ratio and wishes to use a shortcut PE ratio instead, what is the correct PE ratio
to use?
In projecting firm value using a simple PE ratio (that is, one that ignores earningsgrowth), the analyst imposes a strong assumption on the earnings number for a single period: the analyst treats this earnings number (whether it is a trailing earnings
number or a one-period-ahead forecast) as the beginning amount of a permanent
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stream of earnings, valued as a perpetuity. Conceptually, suppose that the firms common shareholders equity value equals its market value, that the firms earnings will
be constant in the future, and that the firms investors expect a rate of return RE.
Under these conditions, we can value the firms common equity using the perpetuity
model based on one-year-ahead earnings (denoted E1), as follows:
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V0 = P0 = E1/RE
Rearranging slightly, the firms VE and PE ratios are:
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V0/E1 = P0/E1 = 1/RE
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Thus, strictly speaking, the PE multiple assumes that firm value is the present value
of a constant stream of expected future earnings, discounted at a constant expected
future discount rate. Under these conditions, the analyst can value the firm simply
using a multiple of one-period-ahead earnings, and the PE ratio of the firm is simply the inverse of the discount rate.
To illustrate this model with an example, assume that the market expects the firm
to generate earnings of $700 next period and requires a 14 percent return on equity
capital. The market value of the firm at the beginning of the next period should be
$5,000 (= $700/0.14). Note that the inverse of the 14 percent discount rate translates
into a PE ratio of 7.14 (= 1/0.14). Thus, $700 times 7.14 equals $5,000.
The simple PE ratio assumes future earnings will be permanent, which is not realistic for most firms. Most firms earnings are not expected to remain constant; most
firms earnings grow. Not surprisingly, such strict assumptions match the fundamental characteristics of very few firms. We have already seen that such strict
assumptions do not fit PepsiCo. Under the assumptions that PepsiCos earnings will
be constant in the future, and that PepsiCos constant future ROCE will equal the 8.0
percent cost of equity capital, then PepsiCos PE ratio should be 12.5 (= 1/0.080).
This PE ratio is far below the theoretically derived VE ratio of 36.0 for PepsiCo.
Descriptive Data on PE Ratios
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The table below includes descriptive statistics of price-earnings ratios (share price
to one-year-ahead earnings: Pt/Et+1, as well as share price to trailing earnings: Pt/Et)
during the years 19912000. These data represent a broad cross-sectional sample of
38,219 firm-years drawn from the Compustat database, excluding all firm-years with
negative earnings.13
Price-Earnings Ratio
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Pt/Et+1
Pt/Et
13
25th percentile
Median
75th percentile
9.60
11.09
13.91
15.72
21.39
24.12
It does not make sense to compute PE ratios on the basis of negative earnings. PE ratios assume earnings
are permanent; negative earnings are not likely to be permanent.
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Exhibit 13.7 includes descriptive statistics on forward-looking PE ratios (share price

to one-year-ahead earnings: Pt/Et+1) for the same 36 industries described in Exhibit
13.3 (MB ratios) and Exhibit 11.3 (market betas) during the years 1991 to 2000.
Exhibit 13.7 lists the industries in ascending order of the median PE ratios. To
describe the industry-wide variation in PE ratios, Exhibit 13.7 also includes the 25th
percentile PE ratio and the 75th percentile PE ratio for each industry.
These descriptive data indicate substantial differences in median PE ratios across
industries during 1991 to 2000. The firms in the forestry, security brokers, and insurance industries experienced the lowest median PE ratios during that period, whereas
firms in the metal mining, business services, communications, and personal services
industries experienced the highest median PE ratios. These data also depict wide
variation in PE ratios across firms within each industry. For example, most of these
36 industries experienced wide differences between the 25th percentile and the 75th
percentile PE ratio during 1991 to 2000. With only a few exceptions, the 75th percentile PE ratio was more than double the 25th percentile PE ratio.14
What Factors Cause the PE Ratio to Differ Across Firms?
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The same set of economic factors that may cause firms MB ratios to differ will also
cause PE ratios to differ. The primary drivers of differences in PE ratios across firms
are the fundamental drivers of value: risk, profitability, and growth. In addition to
economic factors, differences across firms in accounting methods and accounting
principles, and differences across time in accounting earnings, can also drive differences in PE ratios. We describe the effects of each of these determinants of PE ratios
in the sections that follow, saving growth for last because we will expand on the role
of growth in determining PE ratios.
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Risk and the Cost of Capital. As the previous discussion points out, firms with
equivalent amounts of earnings but different levels of risk and therefore different
costs of equity capital will experience different PE ratios (and different VE ratios). All
else equal, more risky firms will experience a lower market value and PE ratio.
However, only firms facing rare circumstances experience PE ratios that equal the
inverse of the equity cost of capital, so a variety of other forces also cause PE ratios
to differ.
Profitability. A firm with competitive advantages will be able to earn ROCE that
exceeds RE. To the extent that the firm can sustain these competitive advantages, the
persistence over time of the degree to which ROCE exceeds RE will increase, thereby
increasing the PE ratio relative to similar firms that do not have sustainable competitive advantages. Thus, both the magnitude and the persistence of the difference
between ROCE and RE will increase PE ratios across firms.
14
The analyst must be careful with PE ratios because they are sensitive to earnings numbers that are near
zero. Firms with earnings that are positive but temporarily very low will experience PE ratios that are
temporarily very high.
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EXHIBIT 13.7
Descriptive Statistics on Share Price to One-Year-Ahead Earnings Ratios (Pt/Et+1),
19912000
75th Percentile
4.5
6.3
7.8
8.8
8.1
8.1
8.4
8.8
11.0
8.4
8.7
9.2
10.8
10.0
8.0
9.7
11.5
10.2
11.4
8.1
9.7
9.7
11.2
8.9
10.7
10.8
12.2
11.3
11.2
10.0
12.5
11.9
14.3
13.4
12.4
12.0
5.8
9.9
10.9
11.5
11.6
11.7
11.8
12.1
12.8
12.8
12.9
13.0
13.0
13.3
13.4
14.4
14.8
14.8
14.9
15.0
15.3
15.6
15.6
15.7
15.7
16.0
16.1
16.6
16.8
17.4
17.6
17.6
18.8
18.8
19.4
21.0
11.3
16.2
16.5
15.6
17.4
17.3
17.2
18.6
17.2
20.5
20.2
21.0
16.1
19.6
24.7
23.9
22.5
21.9
19.7
21.4
25.5
25.4
22.0
27.2
24.8
23.2
23.3
26.6
26.5
26.6
26.5
26.1
24.2
35.0
31.7
37.6
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Median
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Forestry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Security Brokers . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Depository Institutions . . . . . . . . . . . . . . . . . . . . . . .
Lumber . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Transportation by Air . . . . . . . . . . . . . . . . . . . . . . . .
Metal Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Transportation Equipment . . . . . . . . . . . . . . . . . . . .
Tobacco . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
WholesaleDurables . . . . . . . . . . . . . . . . . . . . . . . .
Metals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
WholesaleNondurables . . . . . . . . . . . . . . . . . . . . .
Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Textiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Real Estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Industrial Machinery and Equipment . . . . . . . . . . . .
RetailersGeneral Merchandise . . . . . . . . . . . . . . . .
RetailingApparel . . . . . . . . . . . . . . . . . . . . . . . . . .
Petroleum and Coal . . . . . . . . . . . . . . . . . . . . . . . . . .
Hotels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Motion Pictures . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Electronic and Electric Equipment . . . . . . . . . . . . . .
Printing and Publishing . . . . . . . . . . . . . . . . . . . . . . .
Oil and Gas Extraction . . . . . . . . . . . . . . . . . . . . . . .
Restaurants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Paper . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Grocery Stores . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Health Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Instruments and Related Products . . . . . . . . . . . . . .
Amusements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Chemicals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Food Processors . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Personal Services . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Communication . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Business Services . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Metal Mining . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
25th Percentile
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Industry
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Price-Earnings Ratios (Pt/Et+1)
To compute these descriptive statistics on price-earnings ratios, we divided firm value (computed as year-end closing price times number of shares outstanding) by one-year-ahead net income. We deleted firm-years with negative one-year-ahead net income.
Chapter 13
Accounting Differences. In addition to economic factors, firms PE ratios

may differ for accounting reasonsespecially differences in accounting methods,
principles, and the periodic nature of earnings measurement. Some firms select
accounting methods that are conservative with respect to income recognition and
asset measurement (for example, LIFO for inventories during periods of rising input
prices and accelerated depreciation of fixed assets). Some firms invest in projects for
which accounting principles are conservative. For example, firms may make substantial investments in intangible activities that must be expensed under conservative
accounting principles, leading to economic assets that are off-balance sheet, such as
successful research and development, brand equity, or human capital. The effects of
accounting methods and principles on reported earnings and PE ratios will likely
change over the firms lifetime. All else held equal, conservative accounting will
reduce reported earnings early in the life of the firm (for example, when accelerated
depreciation charges are high or research and development is being expensed),
thereby increasing the PE ratio. Ironically, later in the life of the firm, after the investments have been completely expensed, reported earnings will be higher, and PE
ratios will be lower.
Accounting measures earnings in annual periods. Firms PE ratios will be significantly different when one-period earnings are unusually high or low and therefore
not representative of earnings in perpetuity. For example, if the analyst expects Year
+1 earnings will include an unusual loss that will not persist, then the firms PE ratio
will be unusually high. The transitory nature of a single period of accounting earnings can cause PE ratios to be more volatile than the long-run expectations of earnings warrant. In particular, if the analyst uses PE ratios based on trailing twelve
months earnings that include non-recurring gains or losses that are not expected to
persist, the PE ratios will be artificially volatile.
Continuing the example, assume that the analyst expects the firm to generate
earnings next period of $650 instead of $700 because the firm will recognize a $50
restructuring charge. If the market views this charge as nonrecurring (that is, not a
permanent change in earnings), then the market price should fall to roughly $4,950
(= $5,000 $50) in the no-growth scenario, and the PE ratio for the period will be
7.62 (= $4,950/$650), instead of 7.14 (= $5,000/$700). Conversely, if the current
periods earnings exceed their expected permanent level, then the PE ratio will be less
than normal.
The analyst must assess whether the lower or higher level of earnings for the
period (and therefore higher or lower PE ratio) represents a transitory phenomenon
or a change to a new lower or higher level of permanent earnings. If the analyst
expects the decrease in earnings from $700 to $650 will be permanent, then the
market price (assuming no change in risk or growth) should decrease to $4,643
(= $650/.14). Thus, the PE ratio remains the same at 7.14 (= 1/.14).
To illustrate the effects of accounting differences on PE ratios across firms,
consider the table below, which includes PE ratios (computed as year-end share
price over trailing earnings per share) for PepsiCo and Coca-Cola for the Years 10
and 11.
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Price per
Share
Earnings per
Share
Year 10:
PepsiCo
Coca-Cola
34.2
69.3
$49.56
$60.94
$1.45
$0.88
Year 11:
PepsiCo
Coca-Cola
32.5
29.5
$49.05
$47.15
$1.51
$1.60
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PE Ratio
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Considered at face value, the PE ratios for PepsiCo and Coca-Cola in Year 10 indicate
that the market valued Coca-Colas earnings at a multiple of 69.3, more than twice
PepsiCos earnings multiple of 34.2, implying Coca-Cola had lower cost of capital,
higher growth, and/or greater profitability than PepsiCo. To the contrary, however,
Coca-Cola recognized a restructuring charge in income in Year 10, driving EPS down
to only $0.88, thereby inflating Coca-Colas PE ratio. Thus, the big jump in CocaColas PE ratio occurred largely because earnings temporarily declined that year, and
did not reflect the markets expectations for Coca-Colas long-term earnings. In Year
11, both firms reported earnings closer to normal levels and their PE ratios were
quite similar.
Growth. Holding all else equal, PE ratios will be greater for firms that the market
expects will generate greater earnings growth with future investments in abnormally
profitable projects. In the next section, we discuss techniques analysts use to incorporate earnings growth into PE ratios.
Incorporating Earnings Growth into Price-Earnings Ratios
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Analysts commonly modify the PE ratio to incorporate earnings growth. In this

section, we describe and apply two related approaches to include expected future
earnings growth in the computation of the PE ratio: (1) the perpetuity-with-growth
approach; and (2) the price-earnings-growth approach.15
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The Perpetuity-with-Growth Approach. The perpetuity-with-growth approach

assumes that the firm can be valued as the present value of a permanent stream of
future earnings that will grow at constant rate g. In this case, we can express VE and
PE ratios as perpetuity-with-growth models, as follows:
V0 = P0 = E1 1/(RE g), so V0/E1 = P0/E1 = 1/(RE g)
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To continue the illustration, assume that the market expects the firms earnings will
be $700 next year and will grow 5 percent each year thereafter. The model suggests
15
In recent research, James Ohlson and Beate Juettner-Narouth develop a theoretical model for the priceearnings ratio that incorporates short-term and long-term earnings per share growth. The model
appears to be a promising addition to the earnings-based valuation literature, providing new insights
into the relation between value, earnings, and growth. However, the model has not yet been subject to
extensive empirical testing or practical application. See James Ohlson and Beate Juettner-Nauroth,
Expected EPS and EPS Growth as Determinants of Value, Working Paper, New York University, 2000.
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Chapter 13
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the PE ratio should be 11.11 [= 1.0/(0.14 0.05)] and market value should be $7,778
(= $700 11.11). The present value of the growth in earnings adds $2,778 (= $7,778
$5,000) to the value of the firm.
PE ratios are particularly sensitive to the growth rate. If the growth rate is 6 percent instead of 5 percent, the ratio becomes 12.50 [= 1.0/(0.14 0.06)] and the market value becomes $8,750 (= $700 12.50). The sensitivity occurs because the model
assumes that the firm will grow at the specified growth rate forever. Competition,
new discoveries or technologies, or other factors eventually erode rapid growth rates
in an industry. In using the constant growth version of the PE ratio, the analyst
should select a long-run equilibrium growth rate in earnings.
This expression for the VE and PE ratio underscores the joint importance of risk
and growth in valuation. Given the relation between expected return (RE) and risk, the
VE and PE ratio should be inversely related to risk. Holding earnings and growth constant, higher risk levels should translate into lower PE and VE ratios, and vice versa.
Investors will not pay as much for a higher risk security as for a lower risk security
with identical expected earnings and growth. In contrast, VE and PE should relate
positively to growth. Holding earnings and RE constant, firms with high expected
long-run growth rates in earnings should experience higher VE and PE ratios.
With respect to PepsiCo at the end of Year 11, we assumed that PepsiCo would
experience a long-run growth rate of 5.0 percent. Thus, using the perpetuity-withgrowth approach, we calculate the PE ratio as:
P0/E1 = 1/(RE g) = 1/(0.080 0.050) = 33.33
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Clearly, incorporating growth makes a big difference in PepsiCos PE ratio (as compared to the PE ratio of 12.5 that ignores growth). Assuming PepsiCos earnings grow
at 5.0 percent per year beginning in Year +1, this PE with growth ratio would value
PepsiCo shares at a multiple of 33.33 times the Year +1 earnings forecast. This PE
ratio is still less than the theoretically correct VE ratio of 36.0, however, because it
does not take into account our forecast that PepsiCo earnings would grow at roughly
7.2 percent from Year +1 to Year +10. Thus, this PE ratio understates the value of
PepsiCos expected earnings growth during those years.
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The Price-Earnings-Growth Approach. An alternative ad hoc approach to incorporate growth into PE ratios has emerged from practice in recent years, in which analysts divide the price-earnings ratio by the expected short-term earnings growth rate
(expressed as a percent; some analysts will use the expected earnings growth rate for
the medium-term horizon of 3 to 5 years). This approach produces the so-called
PEG ratio seen with increasing frequency in practice. Analysts compute the PEG
ratio as follows:
PEG0 = (Price per share0/Earnings per share0)/(g 100)
Analysts and the financial press use the PEG ratio as a rule-of-thumb to assess share
price relative to earnings and expected future earnings growth. Although there is little
theoretical foundation for this rule-of-thumb (which tends to vary across analysts),
proponents of PEG ratios generally assert that firms normally have PEG ratios near
1.0, indicating market price fairly reflects expected earnings growth. Using this rule-of-
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PEG11 = (Price per share11/Earnings per share11)/(g 100)

= ($49.05/$1.51)/(0.072 100)
= 32.5/7.2 = 4.51
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thumb, proponents assert that market prices for firms with low PEG ratios (0.5 and
below) are low relative to growth, and market prices for firms with high PEG ratios
(1.5 and above) are high relative to growth. Proponents of PEG ratios argue that this
heuristic provides a convenient means to rank stocks, taking into account one-yearahead earnings and expected earnings growth.16
In Chapter 10, we assumed that PepsiCo would experience earnings growth of
roughly 7.2 percent per year through Year +5. Using this growth rate assumption and
our Year 11 reported earnings per share, we compute PepsiCos PEG ratio at the end
of Year 11 as follows:
939
PE Ratio Measurement Issues
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Thus, PepsiCo shares traded at the end of Year 11 at a PEG ratio of 4.51. Based on the
PEG heuristic, PepsiCos PEG ratio of 4.51 suggests the market price for PepsiCo
shares reflect substantial overpricing of PepsiCos growth. This heuristic does not
take into account, however, the fact that PepsiCos expected future ROCE is significantly greater than PepsiCos RE because of PepsiCos substantial off-balance sheet
brand equity. The PEG ratio deserves considerable attention from researchers and
practitioners so that its uses and limitations can be tested and understood.
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Thus far, we have discussed a variety of different measurement issues for PE ratios.
Forward-looking PE ratios divide share price by one-year-ahead earnings forecasts,
which is theoretically more correct; however, such forecasts are not readily available
for all firms, and they depend on analysts forecast assumptions, which can differ
widely. Therefore, as noted earlier, in practice the analyst is most likely to encounter
PE ratios in the Wall Street Journal or on financial data web sites that are most commonly measured as share price divided by earnings per share for either the most
recent prior fiscal year or the most recent four quarters. This is a sensible approach
because historical earnings are observable and unique; however, computation of PE
ratios using historic earnings introduces the potential for bias. To recap, the analyst
should be aware of (at least) the following two types of measurement error:
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(1) Growth. Simple ratios of price over earnings do not explicitly consider firmspecific differences in long-term earnings growth. The price-earnings ratios
described in the prior sections provide mechanisms that incorporate growth
into price-earnings multiples.
(2) Transitory earnings. Past earnings are historical and may not be indicative of
expected future permanent earnings levels. Insofar as historic earnings
16
Mark Bradshaw demonstrates an empirical link between PEG ratios and sell-side analysts target price
recommendations in The Use of Target Prices to Justify Sell-Side Analysts Stock Recommendations,
Accounting Horizons, Vol. 16, No. 1 (March 2002), pp. 2741.
940
Chapter 13
contain transitory gains or losses, or other elements that are not expected to
recur, it can cause the PE ratio to vary wildly.
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In addition, the analyst must also be aware of the potential bias in PE ratios because
of differences in firms dividend payouts. Dividends displace future earnings. A dividend paid in year t reduces market price by the amount of the dividend, but the dividend is not subtracted from earnings. The dividend paid will cause future earnings
to decline because the firm has paid out a portion of its resources to shareholders.
Price should therefore decline by the present value of the firms foregone amount of
expected future return on assets distributed as dividends. Thus, for dividend-paying
firms, dividends cause a mismatch between current period price and lagged earnings.
To eliminate this mismatch, the analyst should compute a PE ratio with growth for a
dividend-paying firm as follows: (Pt + Dt)/Et = 1/(RE g).
Empirical Properties of PE Ratios
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The theoretical models indicate that the PE ratio is related to R E, the cost of equity
capital, and g, the growth rate in future earnings. Several empirical studies have
examined the relation between PE ratios, risk (measured using market beta), and
growth (measured using realized prior growth rates or analysts forecasts of future
growth). These studies have found that approximately 50 percent to 70 percent of the
variability in PE ratios across firms relates to risk and growth.17
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PE Ratios as Predictors of Future Earnings Growth. Stephen Penman, a leading

scholar in the relation between earnings, book values, and market values, studied the
relation between PE ratios and changes in earnings per share for all firms on the
Compustat database for the years 1968 to 1985.18 For each year, Penman grouped
firms into 20 portfolios based on the level of their PE ratios. He then computed
the percentage change in earnings per share for the formation year, and for each of
the nine subsequent years. Penman then aggregated the results across years. The table
below presents a subset of the aggregate results.
PE Portfolio:
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High . . . . . . . . . . . . . . .
Medium. . . . . . . . . . . . .
Low . . . . . . . . . . . . . . . .
17
Median Percentage Change in Earnings per Share in:

Year 0
3.9%
14.0%
18.4%
Year +1
Year +2
Year +3
Year +4
52.2%
11.8%
4.8%
17.5%
11.6%
10.2%
17.8%
13.7%
12.3%
15.0%
15.8%
13.1%
See William Beaver and Dale Morse, What Determines Price-Earnings Ratios?, Financial Analysts
Journal (JulyAugust 1978), pp. 6576, and Paul Zarowin, What Determines Earnings-Price Ratios:
Revisited, Journal of Accounting, Auditing and Finance (Summer 1990), pp. 439454.
18
Stephen H. Penman, The Articulation of Price-Earnings Ratios and Market-to-Book Ratios and the
Evaluation of Growth, Journal of Accounting Research (Autumn 1996), pp. 235259.
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The results for the formation year are consistent with transitory components in earnings. Firms with high PE ratios experienced low percentage changes in earnings during
the formation year relative to the preceding year. Firms with low PE ratios experienced
high percentage changes in earnings during the formation year. The results for Year 1
after the formation year suggest a counter-balancing effect of the earnings change in the
formation year. A low percentage increase in earnings is followed by a high percentage
earnings increase for the high PE portfolios, and vice-versa for the low PE portfolios.
The results for subsequent years reflect the tendency toward mean reversion in
percentage earnings changes to a level in the mid-teens. This result is consistent with
the data presented in Exhibit 13.4 for ROCE, where Bernard observed a mean reversion in ROCE toward the mid-teens. The mean reversion suggests systematic directional changes in earnings growth over time (that is, serial autocorrelation), but the
reversion takes several years to occur.
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Articulation of MB and PE Ratios. In the same research study, Stephen Penman

also utilized the residual income valuation model and empirical data to examine the
articulation between firms PE and MB ratios.19 Penman predicts that MB should be
normal (that is, equal to one) when the market expects the firm to earn zero residual income in the future. The MB ratio will be high (above one) or low (below one)
if the market expects the firm to earn positive or negative future residual income. At
the same time, Penman predicts that PE ratios will be normal (that is, equal to the
inverse of RE) when the firm earns current period residual income that is equal to
expected future residual income (that is, a firm with current ROCE equal to long-run
expected ROCE, which should equal long-run expected RE). In contrast, PE ratios
should be high when the firm earns current residual income below long-run
expected residual income (that is, current ROCE is unusually low, causing PE to be
high). PE ratios should be low when the firm earns current residual income that is
greater than long-run expected residual income (that is, current ROCE is temporarily high, causing PE to be low.) Thus, MB ratios will be determined primarily by
expected future residual income, whereas PE ratios will be a function of the difference between current and expected future residual income.
To study the articulation of PE and MB ratios, Penman collected data from the
CRSP and Compustat databases on roughly 2,574 firms during the years 19681985.
Each sample year, Penman ranked and grouped these firms into 20 portfolios based
on PE ratios. He also ranked and grouped the same firms each year into 3 MB ratio
portfolios, classifying MB ratios below 0.90 as low, MB ratios above 1.10 as high, and
MB ratios in between as normal.
Exhibit 13.8 presents a matrix summarizing a portion of the results from
Penmans study. Exhibit 13.8 presents residual income figures after assuming a 10.0
percent cost of capital for all firm-years, and after scaling by beginning of period
book value of common equity (so they are essentially residual ROCE figures). We
denote current period residual income as CRI, and future residual income one-yearahead and six-years-ahead as FRI1 and FRI6, respectively.
19
Stephen H. Penman, op cit.
Chapter 13
EXHIBIT 13.8
The Articulation of Market-to-Book (MB) and Price-Earnings (PE) Ratios
MB Ratio Portfolios:
Normal
Low
High
(Portfolios 1520)
CRI < FRI > 0

CRI: 0.50 to 0.07
FRI1: 0.07 to 0.08
FRI6: 0.01 to 0.11
CRI < FRI = 0

CRI: 0.36 to 0.04
FRI1: 0.13 to 0.03
FRI6: 0.06 to 0.07
Normal
(Portfolios 714)
CRI = FRI > 0

CRI: 0.07 to 0.10
FRI1: 0.08 to 0.10
FRI6: 0.11 to 0.14
CRI = FRI = 0
CRI: 0.02 to 0.04
FRI1: 0.02 to 0.04
FRI6: 0.01 to 0.06
CRI = FRI < 0

CRI: 0.05 to 0.00
FRI1: 0.04 to 0.00
FRI6: 0.02 to 0.03
Low
(Portfolios 16)
CRI > FRI > 0

CRI: 0.12 to 0.41
FRI1: 0.12 to 0.25
FRI6: 0.11 to 0.24
CRI > FRI = 0

CRI: 0.05 to 0.22
FRI1: 0.05 to 0.15
FRI6: 0.07 to 0.12
CRI > FRI < 0

CRI: 0.00 to 0.06
FRI1: 0.01 to 0.04
FRI6: 0.03 to 0.05
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High
CRI < FRI < 0

CRI: 0.24 to 0.06
FRI1: 0.13 to 0.06
FRI6: 0.01 to 0.02
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PE Ratio Portfolios:
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Source: We obtained these data from Table 4 in Stephen H. Penman, The Articulation of Price-Earnings Ratios and Market-to-Book Ratios and the
Evaluation of Growth, Journal of Accounting Research Vol. 34, No. 2, Autumn 1996, pp. 235259.
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Penmans research results generally support his predictions and shed light on the
residual income conditions that cause MB ratios and PE ratios to covary. Examining
future residual income across columns of the matrix, Penmans results suggest that MB
ratios correlate positively with future residual income, consistent with the results from
Bernard in Exhibit 13.4. Future residual income is substantially higher for high MB
firms than for low MB firms. Examining the results across rows, high PE ratio firms
tend to have current period residual income that is much lower than future residual
income, suggesting PE ratios for these firms are temporarily high because residual
income is temporarily low. In contrast, firms with low PE ratios tend to have current
residual income amounts that are greater than the future residual income amounts,
suggesting these firms are experiencing low PE ratios because residual income is temporarily high. Penmans results provide intuition about when MB ratios should be
high, low, or normal, and concurrently, when PE ratios should be high, low, or normal.
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SUMMARY OF VE AND PE RATIOS

Summarizing, the VE and PE ratios are determined by:
1.
2.
3.
4.
Risk
Growth
Differences between current and expected future (permanent) earnings
Alternative accounting methods and principles.
Using Market Multiples of Comparable Firms
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The analyst must assess each of these elements when estimating VE and PE ratios,
particularly when evaluating PE ratios based on reported earnings and when projecting PE ratios to value non-traded firms. The theoretical model indicates the factors affecting the PE ratio but does not provide an unambiguous signal of the
correct PE ratio for a particular firm. The analyst should be aware of the following
considerations when using PE ratios:
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1. The PE ratio is particularly sensitive to the cost of equity capital and to the
earnings growth rate because it assumes a firm can grow earnings at that rate
forever. The analyst should select a sustainable long-term growth rate when
applying the PE model.
2. The theoretical PE model does not work when the growth rate in earnings
exceeds the cost of equity capital. Firms are unlikely to grow earnings at rates
exceeding the cost of equity capital forever. Competition will eventually force
growth rates to decrease.
3. The theoretical PE model does not work when the cost of equity capital
and the growth rate in earnings are similar in amount. The denominator of
the theoretical model approaches zero and the theoretical PE ratio becomes
exceeding large.
4. The PE model does not work when earnings are negative.
5. Before concluding that the market is undervaluing or overvaluing a firm
because the actual PE ratio differs from the theoretically correct VE ratio, the
analyst should assess whether earnings of the period include transitory elements. The analyst should adjust the current periods earnings for unusual,
nonrecurring income items before measuring the PE ratio for the period.
6. When comparing actual PE ratios of firms, the analyst should consider the
impact of their use of different accounting methods and principles.
USING MARKET MULTIPLES OF COMPARABLE FIRMS
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The analyst can use the PE and MB ratios of comparable firms to assess the corresponding ratios of publicly traded firms. The analyst can also value firms whose
common shares are not publicly traded by using PE ratios and MB ratios of comparable firms that are publicly traded. The theoretical models assist in this valuation
task by identifying the variables that the analyst should use in selecting comparable
firms. Bhojraj and Lee demonstrate a technique for selecting comparable firms in
multiples-based valuation by computing warranted multiples based on factors that
drive cross-sectional differences in multiples, such as expected profitability, growth,
and cost of capital.20 Alford examined the accuracy of the PE valuation models using
industry, risk, ROCE, and earnings growth as the bases for selecting comparable
20
Sanjeev Bhojraj and Charles M.C. Lee, Who is My Peer? A Valuation-Based Approach to the Selection
of Comparable Firms, Journal of Accounting Research Vol. 40, No. 2 (May 2002), pp. 407439.
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Chapter 13
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firms.21 The results indicate that industry membership, particularly at a three-digit

SIC code level, provides a useful basis for comparisons if firms in the same industry
experience similar profitability, face similar risks, and grow at similar rates. Thus, in
some circumstances, industry membership serves as an effective proxy for the variables in the PE valuation model. However, as the data in Exhibit 13.7 reveal, substantial differences commonly exist in PE ratios of firms within the same industry.
The warranted-multiples approach of Bhojraj and Lee provides a mechanism to
determine comparable companies within industries and across different industries.
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PRICE DIFFERENTIALS22
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To what extent has the market discounted the value of a firms common equity for
risk? On a per-share level, what is the per-share price impact of risk? Is the markets
discount for risk implicit in a firms share price sufficient to compensate for risk? Or
is the discount too large or too small relative to risk? We rely on an adaptation of the
residual income model to address these questions. We use the residual income model
and risk-free rates of return to estimate risk-free value. We then subtract market price
from risk-free value to assess the price differentialthe amount the market has discounted share price for risk.
As we described in detail in the previous chapter, the residual income model
determines the present value of common shareholders equity as follows:
V0 = BV0 +
t =1
NI t (RE BVt 1 )
(1 + RE )t
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To implement this model, the analyst must estimate the cost of equity capital (RE ) for
purposes of computing residual income [NIt (RE BVt1)] and for discounting residual income to present value at 1/(1 + RE ) t. But the state-of-the-art in financial economics does not provide a clear picture of how RE should be determined. Substantial
controversy surrounds expected returns models like the CAPM. What is the appropriate measure for market beta? In addition to market betas, do other risk factors
belong in the expected returns model, such as firm size or some other set of risk factors? Assuming one can identify the appropriate risk factors that are priced in the
market, what are the appropriate risk premia to use to determine expected returns? At
an even more fundamental level, questions arise about whether risk and expected
returns should be measured based on covariation between a firms returns and a market index of returns. These questions arise in part because market-based models like
the CAPM are essentially circularshould stock prices and realized returns be used
to estimate risk to determine expected returns to evaluate stock prices? Or should risk
21
Andrew W. Alford, The Effect of the Set of Comparable Firms on the Accuracy of the Price-Earnings
Valuation Method, Journal of Accounting Research (Spring 1992), pp. 94108.
22
This section relies heavily on Stephen Baginski and James Wahlen, Residual Income Risk, Intrinsic
Values, and Share Prices, The Accounting Review Vol. 78, No. 1 (January 2003), pp. 327351.
Price Differentials
t =1
NI t (RF BVt 1 )
(1 + RF )t
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RFV0 = BV0 +
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and expected returns be based on covariation between a firms returns and an

economy-wide measure of consumption, on the theory that investors risk aversion is
driven by the need to diversify volatility in expected future consumption?
In light of the critical role of risk and expected returns in valuation, and in light
of the uncertainty surrounding how to measure risk and expected returns, the analyst needs a variety of tools to assess the impact of risk on share prices and firm values. One such tool involves computing price differentials. If the analyst substitutes
the prevailing risk-free rate of interest (denoted RF ; for example, the yield on one- to
five-year U.S. Treasury securities) for the cost of equity capital, the residual income
model can be used to determine risk-free value (denoted RFV0), which is an estimate
of the value of the firm in a risk-neutral market:
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Risk-free value represents the value of the firm, based on book value of equity and
forecasts of expected future earnings, in the absence of discounting for risk. On a pershare basis, risk-free value per share represents the hypothetical value at which shares
would trade in a risk-neutral market. Market price of a share of common equity
reflects the risk-discounted value. Therefore, market price can be subtracted from
risk-free value per share to determine the total discount in share price for risk. We
refer to this difference as the price differential (denoted PDIFF), computed as follows:
PDIFF0 = RFV0 MV0
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The analyst can evaluate the price differential to assess whether the market discount
for risk is sufficient to compensate the investor to hold the firms shares and bear risk.
If the analyst assesses that PDIFF0 is large relative to the risk of the firm, then perhaps the firms shares may be over-discounted for risk (undervalued). On the other
hand, if the analyst assesses that PDIFF0 is small relative to firm risk, then perhaps
the firms shares are under-discounted for risk (overvalued). In the next section, we
illustrate how to compute the PDIFF for PepsiCo. In the following section that discusses reverse engineering, we describe and apply more formal methods to gauge the
magnitude of PDIFF.
COMPUTING PDIFF FOR PEPSICO
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To compute the price differential of PepsiCo as of the end of Year 11, we rely on
the forecast assumptions developed in Chapter 10 and the residual income model
developed in the previous chapter. However, instead of using an 8.0 percent cost of
equity capital for PepsiCo for purposes of computing residual income and discounting it to present value, we instead use the risk-free interest rate at the time of the valuation. At the end of Year 11, U.S. Treasury bills with one to five years to maturity
yielded roughly 4.2 percent. Exhibit 13.9 reports the present value of PepsiCos
expected future residual income in Year +1 through Year +10, computed using the 4.2
percent risk-free discount rate.
Chapter 13
EXHIBIT 13.9
Price Differential of PepsiCo:
Present Value of Residual Income in Year +1 through Year +10 after
Discounting at the Risk-Free Rate of Interest
Year +2
Year +3
$3,656.4
$ 3,975.8
$9,466.2
$10,364.7
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Year +1
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$ 3,367.3
Common Shareholders Equity (at beginning of year) . . . . . . .
$ 8,648.0
Required Income (RF BVt1) . . . . . . . . . . . . . . . . . . . . . . . . . .
363.2
$ 397.6
Residual Income [NIt (RF BVt1)] . . . . . . . . . . . . . . . . . . . . .
$ 3,004.1
$3,258.8
$ 3,540.4
Present Value Factors (at RF = 4.2 percent) . . . . . . . . . . . . . . . .

PV Residual Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Sum of PV Residual Income in Year +1 through Year +10 . . . .
0.960
$ 2,883.0
$33,946.3
0.921
$3,001.4
0.884
$ 3,129.4
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COMPREHENSIVE INCOME AVAILABLE FOR

COMMON SHAREHOLDERS . . . . . . . . . . . . . . . . . . . . . . .
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To compute continuing value, we cannot use the perpetuity-with-growth model

[= 1/(r g)], because our long-term growth assumption for PepsiCo is 5.0 percent,
which is greater than the risk-free discount rate of only 4.2 percent. Therefore, we
derive PepsiCos Year +11 residual income, project it to grow uniformly at the longterm growth rate for an arbitrarily long time (until Year +50), and then discount each
year of residual income to present value.23 The present value of continuing value
under this approach is $181,404.5 million. After adding book value of common
equity at the end of Year 11, adjusting for mid-year discounting, and dividing by
the number of shares outstanding, we estimate the PepsiCo shares have a risk-free
value of $130.24. Subtracting the market price at Year 11 of $49.05 per share, we estimate the PDIFF to be $81.19. These computations suggest that PepsiCo shares have
been discounted by the risk-averse market by roughly $81.19 per share below the
value at which they would trade in a hypothetical risk-neutral market, conditional on
the forecast assumptions in Chapter 10. These computations indicate PepsiCo shares
traded at the end of Year 11 at a price equal to roughly 38 percent of risk-free value
(= $49.05/$130.24). Exhibit 13.10 presents these computations.
In Chapters 11 and 12, we estimated that PepsiCo shares may have been underpriced at the end of Year 11. The price differential computation indicates that the market imposed a substantial discount to PepsiCos expected future residual income,
relative to the risk of PepsiCo. To more formally evaluate the relative magnitude of the
price differential, we next turn to the method of reverse engineering market values.
23
Although we compute present value of continuing value over an arbitrarily long horizon, it will nonetheless understate continuing value (and therefore the risk-free value) because the present value computation does not extend to infinity. By using a long horizon, we seek to reduce the understatement.
Price Differentials
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EXHIBIT 13.9
Exhibit 13.9continued
Year +5
Year +6
Year +7
Year +8
Year +9
Year +10
$ 4,312.3
$ 4,649.6
$ 4,991.0
$ 5,350.0
$ 5,734.9
$ 6,147.5
$ 6,590.4
$11,572.9
$12,149.2
$13,380.8
$14,366.6
$15,423.7
$16,556.8
$17,771.4
562.0
603.4
$ 4,139.3
$ 4,429.0
$ 4,746.6
0.848
$ 3,245.6
0.814
$ 3,369.7
0.781
$ 3,460.2
0.750
$ 3,558.9
647.8
695.4
746.4
$ 5,087.1
$ 5,452.1
$ 5,844.0
0.720
$ 3,660.4
0.691
$ 3,764.9
0.663
$ 3,872.9
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$ 3,826.2
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Year +4
EXHIBIT 13.10
Price Differential of PepsiCo
Computations
Valuation Steps
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Sum of PV Residual Income in Year +1

through Year +10
Add Continuing Value in Present Value
Total PV Residual Income

Add: Beginning Book Value of Equity
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Adjust to Midyear
PV of Common Equity
Shares Outstanding
Estimated Value per Share
Current Price per Share
Price Differential
Discounted at the risk-free rate of

interest. See Exhibit 13.9.
Year +11 residual income assumed
to grow at 5.0%; projected to Year
+50, discounted at 4.2%.
Computations not shown.
Amounts
+$ 33,946.3
+$181,404.5
=$215,350.8
Beginning Book Value of Equity from
Year 11 Balance Sheet.
Multiply by 1+(RE/2)
+$ 8,648.0
=$223,998.8
1.021
=$228,702.8
$ 1,756.0
$ 130.24
$
49.05
$
81.19
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Chapter 13
REVERSE ENGINEERING
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Throughout this text we have emphasized the process of using a firms fundamental characteristics to estimate firm value. This process can be characterized
essentially as a puzzle with four missing pieces, or as an equation with four unknown
variables: value, expected future profitability, expected long-run future growth, and
expected risk-adjusted discount rates. Thus far, we have developed forecasts and
expectations about three of the variablesexpected future profitability, long-run
growth, and risk-adjusted discount ratesand we have used them to solve for the
fourth, firm value. In fact, we can make assumptions about any three of the four variables and then solve for the fourth variable.
We can, for example, treat the market value of common equity as one of the
known variables. We can assume that V0 equals market value. We can then build forecasts for any two other variables, and solve for the missing fourth variable. We refer to
this process as reverse engineering stock prices because it takes the valuation process
and reverses it. It is a process in which the analyst takes market value as given, and then
solves for the assumptions the market appears to be making in order to value the firms
stock at market price. For example, if we take a firms market price as given, and if we
use an analysts forecasts for future earnings and growth as reasonable proxies for the
markets expectations, then we can solve for the implied expected risk-adjusted rate of
return on common equity that is consistent with the observed market value, expected
future earnings, and growth. This is essentially equivalent to solving for the internal
rate of return on the stock.
As another example, suppose we take market value as given, we assume that the
risk-adjusted expected return on a stock can be determined by an asset pricing model
such as the CAPM, and we assume analysts consensus earnings forecasts through
Year +5 are reasonable proxies for the markets earnings expectations. We can then
solve for the long-run growth rate implicit in the firms stock price, conditional on
the other assumptions.
The process of reverse engineering stock prices allows the analyst to infer a set of
assumptions that appear to be impounded into the firms share price. The analyst can
then assess whether the assumptions the market appears to be making are realistic,
optimistic, or pessimistic. If the analyst determines that the markets assumptions
seem optimistic, then it suggests the market has overpriced the stock (or perhaps the
analyst is just too pessimistic). Alternatively, if the analyst determines that the markets assumptions are pessimistic, then it suggests the market has underpriced the
stock (or again, the analyst may be wrong). Reverse engineering is a mechanism by
which the analyst can infer and judge the assumptions implicit in a stock price.
REVERSE ENGINEERING PEPSICOS STOCK PRICE

To illustrate the process of reverse engineering, we will apply the approach to
PepsiCo, using the end of Year 11 market price of $49.05 per share. To reverse engineer PepsiCos $49.05 share price, we will again rely on the residual income model in
the previous chapter and the forecasts developed in Chapter 10.
Reverse Engineering
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Assume we want to solve for the expected return (that is, the risk-adjusted discount rate) on PepsiCos stock implied by the Year 11 share price of $49.05. Assume
also that we believe our forecasts of earnings and book value of common equity for
PepsiCo through Year +10 and our forecast of 5.0 percent long-run growth are realistic proxies for the markets expectations. Armed with share price, specific profitability and growth forecasts through Year +10, and a constant long-run growth
assumption beyond Year +10, we can use the residual income value model to solve
for the discount rate that reduces future earnings and book value to a present value
equal to $49.05 per share.
Procedurally, one way to solve for the implied expected return on PepsiCo stock,
conditional on the price, earnings, and growth assumptions, is to begin by estimating the value of common equity using the risk-free discount rate, as in the price differential illustration above. The initial value will likely far exceed the market price
because the future residual income has not been discounted for risk. In applying the
price differential model to PepsiCo in the previous section, we determined that
PepsiCos risk-free value was $130.24 per share. We then steadily increase the discount rate as necessary until the residual income model value exactly agrees with the
market price of $49.05 per share. Following this approach, the implied expected
rate of return on PepsiCo stock is 9.178 percent. At this discount rate, conditional on
the residual income and growth assumptions, the present value of PepsiCo shares is
$49.05 per share, exactly equal to market price. Recall we assumed PepsiCo common
equity had a required rate of return of 8.0 percent based on the CAPM. However, this
reverse engineering approach indicates that if we buy a share of PepsiCo stock at the
market price of $49.05, it will yield a 9.178 percent rate of return, conditional on our
other assumptions. The Valuation spreadsheet in FSAP allows the analyst to make
these iterative computations easily by simply varying the discount rate for equity
capital.
We can also reverse engineer PepsiCos Year 11 stock price to solve for the implicit
long-run growth assumption. To illustrate, we again take the market price of $49.05
per share as given, and our earnings and book value forecasts through Year +10 as
reasonable proxies for the markets expectations. We now return to our original
assumption that the risk-adjusted discount rate for PepsiCo stock is 8.0 percent,
based on the CAPM. With this, we have established three assumptionsvalue, earnings through Year +10, and the risk-adjusted discount rateand we can solve for the
missing piece of the puzzle: long-run implied growth. We begin with the long-run
growth assumption set at zero growth. We compute our first estimate of firm value
using the zero growth assumption, and we compare that estimate to market price.
The first estimate will likely be substantially lower than market price because market
price probably includes the present value of the markets expectations for long-run
growth. For PepsiCo, the initial value estimate assuming zero growth is $38.20 per
share. We steadily increase the long-run growth parameter assumption as necessary
until the present value from the residual income model equals market price. In the
case of PepsiCo at the end of Year 11, market price of $49.05 only reflects long-run
growth of 2.96 percent (significantly lower than our expectation of 5.0 percent longrun growth). That is, conditional on our assumptions for residual income through
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Year +10 and on our assumption that PepsiCos cost of equity capital is 8.0 percent,
if the market expects long-run growth will be 2.96 percent, then the present value of
PepsiCo shares exactly agrees with the market price of $49.05. Again, note that the
Valuation spreadsheet in FSAP is a useful tool that allows the analyst to establish
assumptions for earnings and cost of capital, and then vary the long-run growth
assumption for reverse engineering.
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THE RELEVANCE OF ACADEMIC RESEARCH FOR THE

WORK OF THE SECURITY ANALYST24
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Academic accounting researchers develop and test models to explain the observed
relation between accounting information and stock prices. The research usually proposes theories and models for this relation analytically and then tests the models
empirically on large data sets involving many firms for many years. The results of
this research have provided many insights into multi-faceted dimensions of the relations between accounting numbers and a wide variety of capital market variables
such as stock prices, stock returns reactions around announcements, stock returns
cumulated over long periods of time, trading volume, analysts and managements
earnings forecasts, equity costs of capital, implied market risk premia, market betas,
other risk factors, bankruptcy, earnings management, and many others. Throughout
this text, we have referred to relevant examples of empirical accounting research,
including the classic study by Ball and Brown that helped set the stage for future
research by being the first to show that changes in earnings correlate with unexpected
changes in stock prices.25 As we described in Chapter 1, the Ball and Brown results
indicate that, in their sample, merely the difference in the sign of the change in
annual earnings (whether positive or negative) was associated with nearly a 16 percent difference in annual market-adjusted stock returns. Firms that reported
increases in earnings experienced returns that on average beat the market average
by 7 percent, while firms that reported decreases in earnings experienced returns that
on average fell 9 percent short of the market average.
Accounting academics and the research process itself provide important elements
that should lead to reliable insights into the relation between accounting numbers
and stock market variables. For example, as researchers, academics are trained to base
their predictions and hypotheses as much as possible on formal theory integrating
economics, finance, and accounting (rather than ad hoc or ex post reasoning).
Academics commonly test these predictions with rigorous quasi-scientific methods
on large empirical samples of real data. Academics usually have no commercial interest in the results, so the findings should not be biased by the need to obtain a particular conclusion, or the need to sell. Furthermore, academic research is not published
24
This section draws heavily from Clyde P. Stickney, The Academics Approach to Securities Research: Is
It Relevant to the Analyst? Journal of Financial Statement Analysis (Summer 1997), pp. 5260.
25
Ray Ball and Philip Brown, An Empirical Evaluation of Accounting Income Numbers, Journal of
Accounting Research (Autumn 1968), pp. 159178.
The Relevance of Academic Research for the Work of the Security Analyst
LEVEL OF AGGREGATION ISSUE
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in a leading scholarly research journal until after it passes the stringent peer review
process. Few research studies pass the publish test; most perish.
Despite these strong advantages leading the academic accounting research process
toward reliable conclusions and insights about the relation between accounting
numbers and market variables, the natural question for the security analyst is: Of
what relevance are the academic research models and empirical findings to my task
of making buy, sell, or hold recommendations on individual firms? This concluding
section offers some thoughts on this important question. This section also summarizes the role of market efficiency, and describes some of the empirical evidence to
date on the relative degree of market efficiency with respect to earnings numbers. We
consider the results to date to be very encouraging for analysts.
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Both the academic and professional analyst communities must recognize that their
interests involve different levels of aggregation. The academic is interested primarily
in big picture explanations; conclusions and results that predict and explain the
relation between accounting information and stock market variables in general. The
analyst is concerned with specific assessments of the value of individual firms. The
academic might seek to answer the question, what is the sign and significance of the
relation between investments in research and development and stock market returns?
Does this relation differ across industries? The analyst is more concerned with
whether the specific investments in research and development by a particular firm,
such as Eli Lilly or Intel, are likely to enhance profitability and stock returns. Academic
research describes general tendencies that provide a basis for the analyst to assess the
link between accounting numbers and a firms value, and to identify deviations from
the average for individual firms. Professional analysts create value by acting on the
deviations (that is, taking positions in under- or overpriced stocks). Academics should
not expect immediate application of their research findings to the work of the professional analyst. Professional analysts should not expect to apply the results of academic research immediately and specifically to their day-to-day responsibilities.
THEORY DEVELOPMENT AND PRACTICE FEED EACH OTHER
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The previous section suggests the common meeting place between the academic
and professional analyst communities. Both communities share the desire to understand better how accounting information relates to stock prices. The activities of each
community do influence the other. Academics are keenly interested in predicting and
explaining analysts earnings forecasts and price targets, and, more generally, in
explaining the actions of market participants on the whole. Analysts, directly or indirectly, rely on theories and results from academic research to inform their analysis.
Much of what analysts learn in their academic training (such as in undergraduate
and MBA programs) and in professional development training, is developed and validated by academic work (including textbooks like this one, that seek to link practice,
theory, and research). Consider, for example, the impact that academic research
relating to earnings forecasts, market reactions to earnings, risk and expected
returns, and bankruptcy prediction have had on the work of the securities analyst
952
Chapter 13
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during the last several decades. Consider the success of the academic community to
identify and explain market pricing anomalies, such as why the market does not
fully incorporate information about past earnings changes when making earnings
predictions, and the numerous portfolios and trading strategies that have emerged to
exploit these anomalies.
HAS THE THEORY OF CAPITAL MARKET EFFICIENCY GOTTEN

IN THE WAY?
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For most of the last several decades, academic research has presumed that the capital markets exhibit a relatively high degree of efficiency with respect to accounting
information. In contrast, many analysts view their task as the constant pursuit of
market inefficienciesmispriced securities. Academics generally perceive market
efficiency from the perspective of the big picture, with a view of large samples and
market movements in general, whereas analysts see market efficiency from the front
lines, experiencing daily swings in market prices which are sometimes hard to
explain in the context of an efficient market. Thus, it is not surprising that at times
the differences in perspective on the degree of market efficiency may create more of
a wall, rather than a bridge, between academics and professional analysts. This section seeks to reach a common understanding, and the next section provides some
striking evidence on the degree of market efficiency with respect to earnings.
Capital markets may be described as efficient with regard to accounting information if market prices react completely and quickly to available accounting information. Notice that efficiency should be described as a matter of degree, not as an
absolute. The issue is not whether the capital markets are or are not efficient. Rather,
the issue is the degree to which the capital markets impound in prices all the available value-relevant information.
The term completely in this description implies the degree to which market participants identify the value-relevant implications of all available accounting information so that market prices reflect economic values without systematic bias. For
example, a market that reflects a relatively high degree of information efficiency
would impound in prices the value-relevant information in the persistence of earnings over time, and accounting information disclosed in footnotes as well as in the
financial statements. A market that is relatively efficient will impound in stock prices
the economic implications of all value-relevant accounting information, even
including items such as comprehensive income or pro forma stock options expense,
which may be disclosed in the notes.
The term quickly in this description suggests that market participants cannot
consistently earn abnormal returns using accounting information for a long period
of time after the information has been made publicly available. If capital markets
exhibit a high degree of efficiency, market prices should react quickly (within a
matter of hours or days) to capture any value-relevant signals in the accounting
information.
The degree of efficiency with respect to complete and quick reactions in an
information-efficient capital market depends on analysts and financial statement
analysis. Analysts study accounting information to assess appropriate values for
The Relevance of Academic Research for the Work of the Security Analyst
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stocks and to take positions in under- or overvalued securities, thereby driving stock
market prices to efficient levels. The speed with which analysts can forecast, anticipate, and react to accounting information causes prices to move before accounting
information is released, and to react quickly to surprises in the information when it
is released.
Also consider what a high degree of market efficiency does not imply. A capital
market with a high degree of information efficiency does not necessarily price all
stocks correctly every day. As a practical matter, relatively efficient markets experience valuation errors at the level of the individual firm; but these random inefficiencies cancel out at an aggregated market level and do not tend to persist for long
periods of time.26 Analysts are driving forces involved in identifying and correcting
security mispricings. A capital market with a high degree of information efficiency
does not necessarily have perfect foresightsurprises happen. Firms frequently surprise the market by announcing earnings numbers that are higher or lower than the
markets expectations. Again, analysts drive market prices to react quickly and completely to new information.
953
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STRIKING EVIDENCE ON THE DEGREE OF MARKET

EFFICIENCY AND INEFFICIENCY WITH RESPECT TO EARNINGS
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Two studies by Victor Bernard and Jacob Thomas provide the most striking evidence to date on the degree of market efficiency and inefficiency with respect to
accounting earnings.27 Bernard and Thomas collected a sample of 84,792 quarterly
earnings announcements for firms on the CRSP and Compustat databases over the
years 1974 to 1986. They ranked each firm each quarter into 10 portfolios on the
basis of each firms standardized unexpected earnings (denoted SUEthe seasonal
quarterly change in earnings standardized by the firms standard deviation in
earnings changes over the prior 16 quarters). They studied the average abnormal
(market-adjusted) stock returns to each portfolio over the 60 trading days leading up
to the quarterly earnings announcement, and over the 60 trading days following the
announcement. Exhibit 13.11 depicts a portion of their results.
The results in Exhibit 13.11 during the pre-announcement period indicate that
the market is highly efficient in anticipating and reacting to quarterly earnings surprises. Firms with quarterly earnings surprises in the good news portfoliosportfolios 7 through 10experience positive cumulative abnormal returns during the 60
days prior to and including the release of earnings. Firms with quarterly earnings
surprises in the bad news portfoliosportfolios 1 through 4experience negative
cumulative abnormal returns during the 60 days prior to and including the release of
earnings. The average difference in cumulative abnormal returns between portfolio
26
For a discussion of these issues, see Ray Ball, The Earnings-Price Anomaly, Journal of Accounting and
Economics (1992), pp. 319345.
27
Victor Bernard and Jacob Thomas, Post-Earnings Announcement Drift: Delayed Price Response or Risk
Premium? Journal of Accounting Research Vol. 27, (Supplement, 1989), pp. 136; and Evidence that
Stock Prices Do Not Fully Reflect the Implications of Current Earnings for Future Earnings, Journal of
Accounting and Economics Vol. 13, No. 4 (1990), pp. 305340.
EXHIBIT 13.11
Evidence from Research by Bernard and Thomas on Market Efficiency
with Respect to Standardized Unexpected Earnings (SUE)
ng
6
Pre-announcement Period
Post-announcement Period
SUE
deciles
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10
7
6
SUE
deciles
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10
9
8
7
6
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Cumulative
Abnormal
Returns
0
(%)
Chapter 13
954
5
4
3
2
1
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60
40
20
20
40
60
Event Time in Trading Days Relative to Earnings Announcement Day
Source: Victor Bernard and Jacob Thomas, Post-Earnings Announcement Drift: Delayed Price Response or Risk Premium? Journal of
Accounting Research Vol. 27, (Supplement, 1989), pp.136.
Summary
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10 (roughly +4 percent) and portfolio 1 (roughly 6 percent) was more than 10

percent per quarter! These results suggest the market anticipates and reacts quickly to
quarterly earnings information.
The results in Exhibit 13.11 during the post-announcement period suggest that
the markets reaction to quarterly earnings news is highly, but not completely, efficient. In the post-announcement period, Bernard and Thomas measured the cumulative abnormal returns to the exact same portfolios over the 60 trading days after the
earnings announcements. If the markets reactions to quarterly earnings were on
average quick and complete, these portfolios should exhibit no systematic abnormal
returns in the post-announcement period. Upon the announcement of earnings,
market prices should adjust efficiently. Post-announcement abnormal returns should
only arise from new information that arrives during those 60 days, and the postannouncement abnormal returns should not be associated with the prior quarters
earnings news.
The results for the post-announcement period clearly indicate significant cumulative abnormal returns for the firms in portfolio 10 (best news) and portfolio 1
(worst news). Mean cumulative abnormal returns amount to roughly +2 percent and
2 percent for the best and worst news portfolios, respectively. In their second study,
Bernard and Thomas show that, in part, the market seems to underreact to the persistence in current period earnings for future period earnings, failing to fully anticipate the momentum in quarterly earnings changes.
Taken together, the Bernard and Thomas studies reveal that the market is highly
but not completely efficient with respect to quarterly earnings. We consider these
results to be very encouraging for analysts. We interpret the results to suggest that
analysts who can sharpen their ability to forecast future changes in earnings, and take
long positions in (buy) shares of firms experiencing earnings increases and short
positions in (sell) shares of firms experiencing earnings decreases during the 60-day
pre-announcement period have the potential to earn some portion of the preannouncement abnormal returns. Similarly, analysts who can sharpen their ability to
react appropriately once earnings are announced have some potential to earn a portion of the post-announcement abnormal returns. These findings suggest that there
are returns to be earned by being good at forecasting and reacting to earnings.
We believe the state-of-the-art of market efficiency is exactly where analysts would
like it to be. The market is very efficient with respect to accounting information, but
not perfectly efficient. Some stocks are temporarily mispriced, but the market tends
to correct mispricings in a relatively short period of time. Financial statements analysis, particularly focusing on earnings, can help the analyst identify stocks whose
prices may be temporarily out of equilibrium. Insightful financial statement analysis
can lead to intelligent investment decisions and better-than-average returns.
955
SUMMARY
This chapter relies on the residual income model to develop the theoretical rationale relating market prices to economic drivers of value and to accounting fundamentals. This chapter describes the conceptual basis and practical application of
956
Chapter 13
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market multiplesthe market-to-book value (MB) ratio and the price-earnings

(PE) ratio. The chapter focuses on four variables, or factors, that affect the marketto-book ratio and the price-earnings ratio: (1) risk and the cost of equity capital, (2)
the expected future growth rate in earnings, (3) the presence of permanent and transitory components in the earnings of a particular year, and (4) the effects of accounting methods and principles on reported earnings and the book value of common
shareholders equity. For decades, analysts have relied heavily on PE ratios to relate
market prices to earnings. However, in recent years, analysts and academics alike
increasingly recognize that transitory elements in earnings and earnings growth can
cloud the interpretation of the PE ratio as an indicator of value. Analysts and academics are shifting emphasis to the price-earnings-growth ratio and to the MB ratio.
Transitory earnings elements of a particular period have less effect on the MB ratio.
This chapter also demonstrates techniques to exploit the information in market
value by calculating price differentials and by reverse engineering stock prices to infer
the assumptions the market must be making. The chapter concludes by describing
the relevance of academic research for the professional analyst, including highlighting key research results that appear to be very encouraging for the analyst interested
in using earnings and financial statement data to analyze and value firms.
PROBLEMS
13.1 USING MARKET MULTIPLES TO ASSESS VALUES AND MARKET PRICES.

This problem continues Case 5.2 and Problems 10.7, 11.4, and 12.1 for The Gap and
Limited Brands.
Required
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a. Compute the value-to-book ratio of each firm as of January 1, Year 13, using
the residual ROCE valuation method.
b. Using analyses developed in the case and problems listed above and in part a,
prepare an exhibit summarizing the following ratios for each firm as of
January 1, Year 13:
1. Value-to-book ratio (use the values derived from the value-to-book ratio in
part a).
2. Market-to-book ratio (Problem 11.4 gives market value information).
3. Value-to-earnings ratio, where earnings are reported earnings for Year 12
(Case 5.2 provides reported earnings information).
4. Price-to-earnings ratio, where earnings are reported earnings for Year 12.
5. Value-to-earnings ratio, where earnings are projected earnings for Year 13
(use the amounts of projected earnings in Problem 12.1).
6. Price-to-earnings ratio, where earnings are projected earnings for Year 13.
c. Compute the risk-free value of each firm as of January 1, Year 13, using a riskfree rate of 4.2 percent. Use the projected earnings for Year 13 to Year 17 developed in Problem 10.7, and the projected comprehensive income for Year 18
developed in Problem 12.1. Maintain the continuing value growth assumptions of 6 percent for The Gap and 3 percent for Limited Brands. Forecast
Problems
ni
ng
amounts out 50 years in total (that is, the initial five years plus 45 additional
years). Compute the ratio of market value to risk-free value for each firm as of
January 1, Year 13.
d. Solve for the growth rate in continuing residual income implicitly impounded
in the market value of each firm on January 1, Year 13. Use the residual income
amounts in Problem 12.1 for Year 13 to Year 17 before solving for the growth
rate in continuing residual income.
e. Using the analyses in parts a to d, evaluate the extent of mispricing of each
firm by the market.
957
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13.2 USING MARKET MULTIPLES TO ASSESS VALUES AND MARKET PRICES.

Problem 12.4 presents selected pro forma financial information for Steak N Shake for
Year 12 to Year 22.
Required
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a. Compute the value-to-book ratio as of January 1, Year 12, using the residual
ROCE valuation method.
b. Using analyses developed in part a and in Problem 12.4, prepare an exhibit
summarizing the following ratios for Steak N Shake as of January 1, Year 12:
1. Value-to-book ratio (use the amounts from part a).
2. Market-to-book ratio.
3. Value-to-earnings ratio, where earnings are reported earnings for Year 11
of $21.8 million.
4. Price-to-earnings ratio, where earnings are reported earnings for Year 11.
5. Value-to-earnings ratio, where earnings are projected earnings for Year 12.
6. Price-to-earnings ratio, where earnings are projected earnings for Year 12.
c. Compute the risk-free value of Steak N Shake as of January 1, Year 12, using a
risk-free rate of 4.2 percent. Use the projected earnings for Year 12 to Year 21,
and the projected net income for Year 22 given in Problem 12.4. Maintain the
continuing value growth assumption of 3 percent. Forecast amounts out 50
years in total (that is, the initial ten years plus 40 additional years). Compute
the ratio of market value to risk-free value for Steak N Shake as of January 1,
Year 12.
d. Solve for the growth rate in continuing residual income implicitly impounded
in the market value of Steak N Shake on January 1, Year 12. Use the residual
income amounts in Problem 12.4 for Year 12 to Year 21 before solving for the
growth rate in continuing residual income.
e. Using the analyses in parts a to c, evaluate the extent of mispricing of Steak N
Shake by the market.
13.3 APPLYING VARIOUS VALUATION METHODS FOR COMMON EQUITY.

The Coca-Cola Company (Coke) is a principal competitor of PepsiCo. This problem
asks you to compute the value of Coke using various valuation methods discussed in
Chapters 11 to 13 and to compare the results to those illustrated in the chapters for
PepsiCo. Exhibit 13.12 presents selected information from the actual financial state-
Year 14
$ 9,694
3,733
$11,366
3,930
$13,563
4,171
$15,947
4,426
$11,366
(167)
341
(1,907)
$13,563
(178)
422
(2,031)
(189)
515
(2,163)
$18,536
4,691
(199)
621
(2,304)
ar
(157)
(113)
(1,791)
Year 15
$15,947
Year 16
ni
Year 13
$18,536
$21,345
$21,345
4,973
Year 17a
$24,395
5,122
(212)
743
(2,454)
$24,395
(112)
(199)
(4,079)
$25,127
$ 4,065 $ 3,828 $ 3,958 $ 4,209 $ 4,469 $ 4,746 $ 4,863

(1,188)
(513)
(616)
(653)
(692)
(734)
(389)
(926)
(113)
(1,791)
297
341
(1,907)
47
$ 2,046
163
422
(2,031)
$ 1,896
333
515
(2,163)
$ 2,241
354
621
(2,304)
$ 2,448
376
199
743
(2,454)
$ 2,677
(199)
(4,079)
$
395
so
Net Change in Cash. . . . . . . .
Year 12
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Cash Flow from

Operations . . . . . . . . . . . .
Cash Flow for Investing. . . . .
Cash Flow for Long-term
Debt . . . . . . . . . . . . . . . . .
Cash Flow from
Common Stock . . . . . . . .
Cash Flow for Dividends. . . .
Forecast
Actual
Year 11
Common Equity,
Beginning of Year . . . . . . .
Net Income . . . . . . . . . . . . . .
Other Comprehensive
Income . . . . . . . . . . . . . . .
Change in Common Stock . .
Dividends. . . . . . . . . . . . . . . .
Common Equity, End
of Year . . . . . . . . . . . . . . . .
EXHIBIT 13.12
The Coca-Cola Company
Selected Financial Information
(amounts in millions)
(Problem 13.3)
ng
Chapter 13
958
The amounts for Year 17 result from increasing each income statement and balance sheet amount by the expected long-term growth rate of 6 percent
and then deriving the amounts for the statement of cash flows.
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ments of Coke for Year 11 and the forecasted amounts for Year 12 to Year 16. Exhibit
13.12 also shows the forecasted amounts for Year 17 assuming that all amounts on the
income statement and balance sheet for Year 16 grow 6 percent. The market equity
beta for Coke is 0.419. Assume a risk-free interest rate of 4.2 percent and a market risk
premium of 5 percent. The market value of Coke on January 1, Year 12, is $117,214.9
million (2,486 million shares outstanding at a market price per share of $47.15).
Required
a. Compute the value of Coke on January 1, Year 12, using the present value of
projected free cash flows to common equity capital.
b. Repeat part a using the dividends discount model.
c. Repeat part a using the residual income model.
d. Repeat part a using the residual ROCE model.
Problems
PepsiCo
9.96
ar
45.60
ni
14.02
32.40
35.99
Le
Value-to-Book Ratio:
$121,205.9/$8,648 . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Market-to-Book Ratio:
$86,131.8/$8,648 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Value-Earnings Ratio (Year 11 Actual Net
Income): $121,205.9/$2,658 . . . . . . . . . . . . . . . . . . . . .
Price-Earnings Ratio (Year 11 Actual Net
Income): $86,131.8/$2,658 . . . . . . . . . . . . . . . . . . . . . .
Value-Earnings Ratio (Year 12 Projected Net
Income): $121,205.9/$3,367.3 . . . . . . . . . . . . . . . . . . . .
Price-Earnings Ratio (Year 12 Projected Net
Income): $86,131.8/$3,367.3 . . . . . . . . . . . . . . . . . . . . .
Year 16 Forecasted Financial Ratios:
Profit Margin for ROA . . . . . . . . . . . . . . . . . . . . . . . . .
Total Assets Turnover . . . . . . . . . . . . . . . . . . . . . . . . . .
Rate of Return on Assets . . . . . . . . . . . . . . . . . . . . . . . .
Profit Margin for ROCE . . . . . . . . . . . . . . . . . . . . . . . .
Capital Structure Leverage Ratio . . . . . . . . . . . . . . . . .
Rate of Return on Common Shareholders Equity. . . .
Coke
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EXHIBIT 13.13
PepsiCo and Coke
Value and Market Multiples and Financial Ratios
(dollar amounts in millions)
(Problem 13.3)
959
25.58
12.1%
1.26
15.3%
12.2%
2.37
36.4%
19.3%
.72
14.0%
18.5%
1.62
21.7%
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e. Exhibit 13.13 shows the amounts for various multiples for PepsiCo as of
January 1, Year 12. This exhibit also shows financial ratios from the forecast
financial statements for each firm for Year 16. Enter the missing amounts in
Exhibit 13.13 for Coke.
f. Using the analyses in parts a to e, evaluate the extent of mispricing of PepsiCo
and Coke by the market.
Th
13.4 INTERPRETING MARKET-TO-BOOK RATIOS. Exhibit 13.14 presents

selected data for seven pharmaceutical companies for a recent year. The growth rate
in earnings and the dividend payout ratios are five-year averages. The excess earnings
years represent the number of years that each firm would need to earn a rate of
return on common shareholders equity (ROCE) equal to that in Exhibit 13.14 in
order to produce the market-to-book ratios shown. For example, Bristol-Myers
Squibb would need to earn an ROCE of 48.9 percent for 58.3 years in order for the
present value of the excess earnings over the cost of equity capital to produce a
market-to-book ratio of 13.9 when applying the theoretical model. For several years
just prior to the most recent year, Bristol-Myers Squibb recognized significant estimated losses related to breast implant claims.
Chapter 13
960
EXHIBIT 13.14
Selected Data for Pharmaceutical Companies
(Problem 13.4)
Bristol-Myers Squibb . . . . . . . . . .
Warner Lambert. . . . . . . . . . . . . .
Eli Lilly . . . . . . . . . . . . . . . . . . . . .
Pfizer . . . . . . . . . . . . . . . . . . . . . .
Abbott Laboratories. . . . . . . . . . .
Merck . . . . . . . . . . . . . . . . . . . . . .
Wyeth . . . . . . . . . . . . . . . . . . . . . .
13.9
13.0
12.4
11.2
10.4
10.3
6.9
.489
.350
.281
.350
.428
.331
.340
.134
.133
.155
.143
.113
.154
.138
.77
.48
.42
.43
.39
.46
.51
PE
Excess
Earnings
Years
32.4
42.7
49.3
40.4
26.9
31.8
25.0
.068
.051
.110
.152
.116
.130
.065
58.3
32.2
89.8
27.8
13.5
41.9
24.6
ng
ROCE
Growth
in
Earnings
ni
MB
Dividend
Payout
Percentage
ar
Company
Cost of
Equity
Required
Le
Considering the variables in the theoretical market-to-book ratio, discuss the

likely reasons for the ordering of these seven companies on their market-to-book
ratios.
13.5 SENSITIVITY OF THE THEORETICAL MODELS OF PRICE-EARNINGS

AND MARKET-TO-BOOK TO CHANGES IN ASSUMPTIONS. This problem
explores the sensitivity of the price-earnings and market-to-book models to changes
in underlying assumptions. We recommend that you design a computer spreadsheet
to perform the calculations, particularly for the market-to-book ratio.
so
Required
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a. Compute the price-earnings ratio under each of the following sets of

assumptions:
Scenario
Cost of Equity Capital
Growth Rate in Earnings
A
B
C
D
E
F
G
H
I
.15
.15
.15
.13
.13
.13
.11
.11
.11
.06
.08
.10
.06
.08
.10
.06
.08
.10
Cases
.20
.18
.14
.18
.18
.18
.18
.18
.18
.13
.13
.13
.15
.11
.13
.13
.13
.13
.30
.30
.30
.30
.30
.40
.20
.30
.30
10
10
10
10
10
10
10
15
20
ni
A
B
C
D
E
F
G
H
I
Years of
Excess
Earnings
ar
ROCE
Dividend
Payout
Percentage
Le
Scenario
Cost of Equity
Capital
ng
b. Assess the sensitivity of the price-earnings ratio to changes in the cost of

equity capital and changes in the growth rate.
c. Compute the market-to-book ratio under each of the following sets of
assumptions:
d. Assess the sensitivity of the market-to-book ratio to changes in the assumptions made about the various underlying variables.
CASES
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Note: To provide up-to-date integrated valuation cases, we include cases for

Chapters 11 to 13 on the web site for this book (http://stickney.swlearning.com)
instead of the text.
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VALUATION: MARKET-BASED

1. Understand the practical advantages and disadvantages of

3. Understand and estimate the firms value-earnings ratio (VE) as

5. Estimate the price differentialthe difference between market

Introduction and Overview

6. Reverse engineer the firms stock price by using the residual

INTRODUCTION AND OVERVIEW

7. Understand the role of market efficiency in valuation, and the

Chapters 1 to 12 have all focused on using the information in a firms accounting

Valuation: Market-based Approaches

Pro Forma Financial Statement Forecasts

Fundamental Value Drivers over the Remaining Life of the Firm:

Summary Accounting Numbers:

Fundamental Value Drivers over the Remaining Life of the Firm:

Market Multiples of Accounting Numbers

MARKET MULTIPLES OF ACCOUNTING NUMBERS

Valuation: Market-based Approaches

MARKET-TO-BOOK AND VALUE-TO-BOOK RATIOS1

A THEORETICAL MODEL OF THE VALUE-TO-BOOK RATIO

Market-to-Book and Value-to-Book Ratios

Valuation: Market-based Approaches

Market-to-Book and Value-to-Book Ratios

Valuation: Market-based Approaches

Example 1. Suppose an analyst is evaluating a firm with $1,000 of book value of

Market-to-Book and Value-to-Book Ratios

We described above a number of economic reasons why VB and MB ratios may

REASONS WHY VB RATIOS AND MB RATIOS MAY DIFFER

Valuation: Market-based Approaches

EMPIRICAL DATA ON MB RATIOS

EMPIRICAL RESEARCH RESULTS ON THE PREDICTIVE POWER

Market-to-Book and Value-to-Book Ratios

Full Sample* on Compustat

Valuation: Market-based Approaches

Cumulative Percent Increase in

Victor L. Bernard, Accounting-Based Valuation Methods, Determinants of Market-to-Book Ratios and

Application of the Value-to-Book Model to PepsiCo

reversion in ROCEs over time, consistent with movement toward competitive

APPLICATION OF THE VALUE-TO-BOOK MODEL TO

In Chapter 12, we estimated PepsiCos share value at the end of Year 11 to be

Valuation: Market-based Approaches

COMPREHENSIVE INCOME AVAILABLE FOR

ContinuingValue 0 = [(NI 10 (1 + g )/ BV10 ) RE ] [BV10 / BV0 ] [1 / (RE g )] [1 / (1 + RE )10 ]

Application of the Value-to-Book Model to PepsiCo

Present Value of Residual ROCE in Year +1 through Year +10 . . . . . . . . . .

Necessary Adjustments to Compute the Value-to-Book Ratio

Present Value of Residual ROCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Valuation: Market-based Approaches

Sum of PV Residual ROCE in Year +1

Total PV Residual ROCE

See Exhibit 13.5.

Year +11 residual ROCE assumed to

Beginning Book Value of Equity from

(Positive number indicates

Price-Earnings and Value-Earnings Ratios

PRICE-EARNINGS AND VALUE-EARNINGS RATIOS

A THEORETICAL MODEL FOR THE VALUE-EARNINGS RATIO

Valuation: Market-based Approaches

Or equivalently, on a per-share basis as:

Vps 0 /Eps1 = ($121,205.9 million/1,756 million shares)/($3,367.3 million/

V0/E1 = V0/BV0 BV0/E1 = V0/BV0 (1/ROCE1)

V0/E1 = V0/BV0 BV0/E1 = V0/BV0 (1/ROCE1)

Price-Earnings and Value-Earnings Ratios

(sometimes referred to as the trailing-twelve-months earnings).10 The Wall Street