AFMP4
Syllabus B. Advanced Investment Appraisal B4. Valuation and the use of free cash flows

B4a/C2c. Using PE ratio 4 / 11

Syllabus B4a/C2c)

B4a) Apply asset based, income based and cash flow based models to value equity. Apply appropriate models, including term structure of interest rates, the yield curve and credit spreads, to value corporate debt.

C2c) Discuss, assess and advise on the value created from an acquisition or merger of both quoted and unquoted entities using models such as:

ii) Market based models

Take the earnings of the company you are trying to value and multiply it by the average P/E ratio of their industry

Income based methods like this are best used when

  • When taking control of a company

  • When more interested in earnings than dividend policy

Price Earnings Ratio

It essentially tells us is how long it would take the earnings to repay the share price

Ok so this is how it is calculated...

But what we are more concerned with here is how to use this to calculate the value of a business, again here is the formula to use to calculate the value of ONE share..

How to calculate the value of ONE share

How to calculate the value of the WHOLE business

Or...

Both of these give the value of the company as a whole..

HOWEVER, to value a target company you need to use THEIR earnings and our own P/E ratio or at least a P/E ratio from their industry

Also note: The PE can be adjusted down by 10 - 20%

If private company (as less liquid shares)
If risky company (fewer controls etc)

Share Capital (25c) $100,000
Profit before tax $260,000
Tax (120,000)
Preference Dividend ($20,000)
Ordinary Dividend ($36,000)
Retained $84,000

PE (for similar company) =  12.5

What is the value of 200,000 shares?

Solution
Value of Company = PE x Earnings (PAT - Pref divs)

Total Earnings (of 200,000 shares)
140,000 - 20,000 = 120,000 x 200/400 = 60,000

PE 12.5

60,000 x 12.5 = $750,000

Use of predator's P/E ratios

A predator company may use their higher P/E ratio to value a target company.

This use of a higher P/E ratio is known as bootstrapping

  • An illustration:

    Cow Co. (Predator) is valuing a potential acquisition target, Calf Co. (Target), using a bootstrapping approach.

    The following items will be used in a valuation calculation:

    Calf's Earning
    Cow's P/E

Drawbacks Of PE model

  1. Finding a quoted company that is similar in activity (most have a wide range)

  2. A single year’s PE ratio may not be representative

  3. The quoted company used to get the PE ratio from may have a totally different capital structure