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http://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/pbv.html
Defining the return on equity (ROE) = EPS0 / Book Value of Equity, the value of equity can be written as:
If the return on equity is based upon expected earnings in the next time period, this can be simplified to,
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The price-book value ratio of a stable firm is determined by the differential between the return on equity and the required rate of return on its
projects.
Illustration 13: Estimating the PBV ratio for a stable firm with dividends- Amoco
Amoco had earnings per share of $3.82 in 1994, and paid out 60% of its earnings as dividends that year. The growth rate in earnings and
dividends, in the long term, is expected to be 6%. The return on equity at Amoco in 1994 was 15%. The beta for Amoco is 0.65 and the
treasury bond rate is 7.5%.
Current Dividend Payout Ratio = 60%
Expected Growth Rate in Earnings and Dividends = 6%
Return on Equity =15%
Cost of Equity = 7.5% + 0.65*5.5% = 11.08 %
PBV Ratio based on fundamentals = 0.15 * 0.60 *1.06 / (.1108 -.06) = 1.88
PBV Ratio based upon return differential = (0.15 - 0.06) / (0.1108 - 0.06) = 1.77
Amoco was selling at a P/BV ratio of just about 2.00 on the day of this analysis. (March 1995)
P/BV and ROE for Oil Companies - 1995
Company
Elf
Aquitane
Amerada
Hess
Getty
Murphy Oil
Ashland Oil
Repsol
Royal
Dutch
Texaco
Occidental
Pete
Mobil
Chevron
Corp
Amoco
Exxon Corp
British
Petroleum
Unocal
ROE
36
29.6
1.22
5.0%
45
32.65
1.38
3.5%
12
42
34
27
8.15
27.95
21.23
15.35
1.47
1.50
1.60
1.76
11.0%
7.5%
12.4%
15.5%
107
58.95
1.82
12.0%
61
33.15
1.84
11.0%
19
9.95
1.91
9.5%
85
44.5
1.91
13.0%
44
22.2
1.98
13.0%
59
62
28.85
28.3
2.05
2.19
15.0%
15.0%
80
33.6
2.38
15.0%
27
11.3
2.39
13.0%
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Atlantic
Richfield
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/pbv.html
103
38.9
2.65
OIL COMPANIES: P/BV AND ROE
Assume that you have been asked to value a PEMEX for the Mexican Government; All you know is that it has earned a return on equity of
14% last year. The appropriate P/BV ratio can be estimated in one of two ways
Beta based upon international oil companies = 0.70
Cost of Equity = 7.50% + 0.70 (5.50%) = 11.35%
P/BV Ratio (based upon fundamentals) = (0.14 - 0.06) / (.1135 - 0.06) = 1.50
P/BV Ratio (based upon regression) = 0.91 + 8.26 * 0.14 = 2.07
Illustration 14: Estimating the price-book value ratio for a 'privatization' candidate - Jenapharm (Germany)
Jenapharm was the most respected pharmaceutical manufacturer in East Germany.
Jenapharm, which was expected to have revenues of 230 million DM in 1991, also was expected to make earnings before interest and taxes of
30 million DM.
The firm had a book value of assets of 110 million DM, and a book value of equity of 58 million DM. The interest expenses in 1990 amounted
to 15 million DM.
The firm was expected to maintain sales in its niche product, a contraceptive pill, and grow at 5% a year in the long term, primarily by
expanding into the generic drug market.
The average beta of pharmaceutical firms traded on the Frankfurt Stock exchange wass 1.05, though many of these firms had much more
diversified product portfolios and less volatile cashflows.
Allowing for the higher leverage and risk in Jenapharm, a beta of 1.25 was used for Jenapharm. The ten-year bond rate in Germany at the time
of this valuation was 7%, and the risk premium for stocks over bonds is assumed to be 3.5%.
Valuing Jenapharm
Expected Net Income = (EBIT - Interest Expense)*(1-t) = (30 - 15) *(1-0.4) = 9 mil DM
Return on Equity = Expected Net Income / Book Value of Equity = 9 / 58 = 15.52%
Cost on Equity = 7% + 1.25 (3.5%) = 11.375%
Price/Book Value Ratio = (ROE - g) / (r - g) = (.1552 - .05) / (.11375 - .05) = 1.65
Estimated MV of equity = BV of Equity * Price/BV ratio = 58 * 1.65 = 95.70 mil DM
PBV Ratio for a high growth firm
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When the growth rate is assumed to be constant after the initial high growth phase, the dividend discount model can be written as follows:
Rewriting EPS0 in terms of the return on equity, EPS0 = BV0*ROE, and bringing BV0 to the left hand side of the equation, we get
Illustration 15: Estimating the PBV ratio for a high growth firm in the two-stage model
Assume that you have been asked to estimate the PBV ratio for a firm which has the following characteristics:
Growth rate in first five years = 20% Payout ratio in first five years = 20%
Growth rate after five years = 8% Payout ratio after five years = 68%
Beta = 1.0 Riskfree rate = T.Bond Rate = 6%
Return on equity = 25%
Required rate of return = 6% + 1(5.5%)= 11.5%
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http://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/pbv.html
The ratio of price to book value is strongly influenced by the return on equity.
A lower return on equity affects the price-book value ratio directly through the formulation specified in the prior section and
indirectly, by lowering the expected growth or payout.
Expected growth rate = Retention Ratio * Return on Equity
Illustration 17: Return on Equity and Price-Book Value
Assume that a firm has the following characteristics:
Return on Equity = 25%
Growth rate in first five years= 20% Payout ratio in first five years =20%
Growth rate after five years = 8% Payout ratio after five years = 68 %
Beta = 1.0 Required rate of return = 11.5%
Note that the growth rate in first five years = Retention ratio * ROE = 0.8 * 25% = 20%
and the growth rate after year 5 = Retention ratio * ROE = 0.32 * 25% = 8%
The drop in the ROE has a two-layered impact. First, it lowers the growth rate in earnings and/or the expected payout ratio, thus having an
indirect effect on the P/BV ratio. Second, it reduces the P/BV ratio directly.
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Note that when the return on equity is equal to the required return, the price is equal to the book value.
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