As mentioned earlier, this chapter applied the growing-perpetuity formula to the valuation of stocks. In our application, we discounted dividends, not earnings. This is sensible since investors select a stock for what they can get out of it. They only get two things out of a stock: dividends and the ultimate sales price, which is determined by what future investors expect to receive in dividends.
The calculated stock price would be too high were earnings to be discounted instead of dividends. As we saw in our estimation of a firm’s growth rate, only a portion of earnings goes to the stockholders as dividends. The remainder is retained to generate future dividends. In our model, retained earnings are equal to the firm’s investment. To discount earnings instead of dividends would be to ignore the investment that a firm must make today in order to generate future returns.
The No-Dividend Firm
Students frequently ask the following questions: If the dividend-discount model is correct, why aren’t no-dividend stocks selling at zero? This is a good question and gets at the goals of the firm. A firm with many growth opportunities is faced with a dilemma. The firm can pay out dividends now, or it can forgo dividends now so that it can make investments that will generate even greater dividends in the future. This is often a painful choice, because a strategy of dividend deferment may be optimal yet unpopular among certain stockholders.
Many firms choose to pay no dividends—and these firms sell at positive prices. Rational shareholders believe that they will either receive dividends at some point or they will receive something just as good. That is, the firm will be acquired in a merger, with the stockholders receiving either cash or shares of stock at that time.
Of course, the actual application of the dividend-discount model is difficult for firms of this type. Clearly, the model for constant growth of dividends does not apply. Though the differential growth model can work in theory, the difficulties of estimating the date of first dividend, the growth rate of dividends after that date, and the ultimate merger price make application of the model quite difficult in reality.
Empirical evidence suggests that firms with high growth rates are likely to pay lower dividends, a result consistent with the above analysis. For example, consider McDonald’s Corporation. The company started in the 1950s and grew rapidly for many years. It paid its first dividend in 1975, though it was a billion-dollar company (in both sales and market value of stockholder’s equity) prior to that date. Why did it wait so long to pay a dividend? It waited because it had so many positive growth opportunities, that is, additional locations for new hamburger outlets, to take advantage of.
Utilities are an interesting contrast because, as a group, they have few growth opportunities. Because of this, they pay out a large fraction of their earnings in dividends. For example, Consolited Edison, Sempra Energy, and Kansas City Power and Light have had payout ratios of over 70 percent in many recent years.
PRICE-EARNINGS RATIO
This explanation seems to hold fairly well in the real world. Electronic and other high-tech stocks generally sell at very high P/E ratios (or multiples, as they are often called) because they are perceived to have high growth rates. In fact, some technology stocks sell at high prices even though the companies have never earned a profit. The P/E ratios of these companies are infinite. Conversely, railroads, utilities, and steel companies sell at lower multiples because of the prospects of lower growth.
Of course, the market is merely pricing perceptions of the future, not the future itself.
We will argue later in the text that the stock market generally has realistic perceptions of a firm’s prospects. However, this is not always true. In the late 1960s, many electronics firms were selling at multiples of 200 times earnings. The high perceived growth rates did not materialize, causing great declines in stock prices during the early 1970s. In earlier decades, fortunes were made in stocks like IBM and Xerox because the high growth rates were not
anticipated by investors.
One of the most puzzling phenomena to American investors has been the high P/E ratios in the Japanese stock market. The average P/E ratio for the Tokyo Stock Exchange has varied between 40 and 100 in recent years, while the average American stock had a multiple of around 25 during this time. Our formula indicates that Japanese companies have been perceived to have great growth opportunities. However, American commentators have frequently suggested that investors in the Japanese markets have been overestimating these
growth prospects.13 This enigma (at least to American investors) can only be resolved with the passage of time. Some selected country average P/E ratios appear in Table 5.2. You can see Japan’s P/E ratio has trended down.
There are two additional factors explaining the P/E ratio. The above formula shows that the P/E ratio is negatively related to the firm’s discount rate.
We have already suggested that the discount rate is positively related to the stock’s risk or variability. Thus, the P/E ratio is negatively related to the stock’s risk. To see that this is a sensible result, consider two firms, A and B, behaving as cash cows. The stock market expects both firms to have annual earnings of $1 per share forever. However, the earnings of firm A are known with certainty while the earnings of firm B are quite variable. A rational stockholder is likely to pay more for a share of firm A because of the absence of risk. If a share of firm A sells at a higher price and both firms have the same EPS, the P/E ratio of firm A must be higher.
The second additional factor concerns the firm’s choice of accounting methods. Under current accounting rules, companies are given a fair amount of leeway. For example, consider inventory accounting where either FIFO or LIFO may be used. In an inflationary environment, FIFO (first in–first out) accounting understates the true cost of inventory and hence inflates reported earnings. Inventory is valued according to more recent costs under LIFO (last in–first out), implying that reported earnings are lower here than they would be under FIFO. Thus, LIFO inventory accounting is a more conservative method than FIFO. Similar accounting leeway exists for construction costs (completed-contracts versus percentage-of-completion methods) and depreciation (accelerated depreciation versus straight-line depreciation).
As an example, consider two identical firms, C and D. Firm C uses LIFO and reports earnings of $2 per share. Firm D uses the less conservative accounting assumptions of FIFO and reports earnings of $3 per share. The market knows that both firms are identical and prices both at $18 per share. This price-earnings ratio is 9 ($18/$2) for firm C and 6 ($18/$3) for firm D. Thus, the firm with the more conservative principles has the higher P/E ratio.
This last example depends on the assumption that the market sees through differences in accounting treatments. A significant portion of the academic community believes that the market sees through virtually all accounting differences. These academics are adherents of the hypothesis of efficient capital markets, a theory that we explore in great detail later in the text. Though many financial people might be more moderate in their beliefs regarding this issue, the consensus view is certainly that many of the accounting differences are seen
through. Thus, the proposition that firms with conservative accountants have high P/E ratios is widely accepted.
This discussion argued that the P/E ratio is a function of three different factors. A company’s ratio or multiple is likely to be high if it has many growth opportunities, it has low risk, and it is accounted for in a conservative manner. While each of the three factors is important, it is our opinion that the first factor is much more so. Thus, our discussion of growth is quite relevant in understanding price-earnings multiples.
STOCKMARKET REPORTING
The Wall Street Journal, the New York Times, or your own local newspaper provides useful information on a large number of stocks in several stock exchanges. Table 5.3 reproduces what has been reported on a particular day for several stocks listed on the New York Stock Exchange. In Table 5.3, you can easily find the line for General Electric (i.e., “GenElec”). Reading left to right, the first two numbers are the high and low share prices over the last 52 weeks.
For example, the highest price that General Electric traded for at the end of any particular day over the last 52 weeks was $6050. This is read as 60 and the decimal . The stock symbol for General Electric is GE. Its annual dividend is $0.55. Most dividend-paying companies such as General Electric pay dividends on a quarterly basis. So the annual dividend is actually the last quarterly dividend of multiplied by 4 (i.e., .138 ϫ 4 ϭ $0.55).
Some firms like GenenTech do not pay dividends. The Div column for GenenTech is blank. The “Yld” column stands for dividend yield. General Electric’s dividend yield is the current annual dividend, $0.55, divided by the current closing daily price, which is $5663 (you can find the closing price for this particular day in the next to last column). Note that $0.55/5663 Х 1.0 percent. The next column is labeled PE, which is the symbol for the price-earnings ratio. The price-earnings ratio is the closing price divided by the current earnings per share (based upon the latest quarterly earnings per share multiplied by 4). General Electric’s price-earnings ratio is 51. If we were financial analysts or investment bankers, we
would say General Electric “sells for 51 times earnings.” The next column is the volume of shares traded on this particular day (in hundreds). For General Electric, 18,305,100 shares traded. This was a heavy trading day for General Electric. The last columns are the High, the Low, and the Last (Close) share prices on this day. The “Net Chg” tells us that the General Electric closing price of $5663 was lower than its closing price on the previous day by 144. In other words, the price of General Electric dropped from $5807 to $5663, in one day.
The calculated stock price would be too high were earnings to be discounted instead of dividends. As we saw in our estimation of a firm’s growth rate, only a portion of earnings goes to the stockholders as dividends. The remainder is retained to generate future dividends. In our model, retained earnings are equal to the firm’s investment. To discount earnings instead of dividends would be to ignore the investment that a firm must make today in order to generate future returns.
The No-Dividend Firm
Students frequently ask the following questions: If the dividend-discount model is correct, why aren’t no-dividend stocks selling at zero? This is a good question and gets at the goals of the firm. A firm with many growth opportunities is faced with a dilemma. The firm can pay out dividends now, or it can forgo dividends now so that it can make investments that will generate even greater dividends in the future. This is often a painful choice, because a strategy of dividend deferment may be optimal yet unpopular among certain stockholders.
Many firms choose to pay no dividends—and these firms sell at positive prices. Rational shareholders believe that they will either receive dividends at some point or they will receive something just as good. That is, the firm will be acquired in a merger, with the stockholders receiving either cash or shares of stock at that time.
Of course, the actual application of the dividend-discount model is difficult for firms of this type. Clearly, the model for constant growth of dividends does not apply. Though the differential growth model can work in theory, the difficulties of estimating the date of first dividend, the growth rate of dividends after that date, and the ultimate merger price make application of the model quite difficult in reality.
Empirical evidence suggests that firms with high growth rates are likely to pay lower dividends, a result consistent with the above analysis. For example, consider McDonald’s Corporation. The company started in the 1950s and grew rapidly for many years. It paid its first dividend in 1975, though it was a billion-dollar company (in both sales and market value of stockholder’s equity) prior to that date. Why did it wait so long to pay a dividend? It waited because it had so many positive growth opportunities, that is, additional locations for new hamburger outlets, to take advantage of.
Utilities are an interesting contrast because, as a group, they have few growth opportunities. Because of this, they pay out a large fraction of their earnings in dividends. For example, Consolited Edison, Sempra Energy, and Kansas City Power and Light have had payout ratios of over 70 percent in many recent years.
PRICE-EARNINGS RATIO
This explanation seems to hold fairly well in the real world. Electronic and other high-tech stocks generally sell at very high P/E ratios (or multiples, as they are often called) because they are perceived to have high growth rates. In fact, some technology stocks sell at high prices even though the companies have never earned a profit. The P/E ratios of these companies are infinite. Conversely, railroads, utilities, and steel companies sell at lower multiples because of the prospects of lower growth.
Of course, the market is merely pricing perceptions of the future, not the future itself.
We will argue later in the text that the stock market generally has realistic perceptions of a firm’s prospects. However, this is not always true. In the late 1960s, many electronics firms were selling at multiples of 200 times earnings. The high perceived growth rates did not materialize, causing great declines in stock prices during the early 1970s. In earlier decades, fortunes were made in stocks like IBM and Xerox because the high growth rates were not
anticipated by investors.
One of the most puzzling phenomena to American investors has been the high P/E ratios in the Japanese stock market. The average P/E ratio for the Tokyo Stock Exchange has varied between 40 and 100 in recent years, while the average American stock had a multiple of around 25 during this time. Our formula indicates that Japanese companies have been perceived to have great growth opportunities. However, American commentators have frequently suggested that investors in the Japanese markets have been overestimating these
growth prospects.13 This enigma (at least to American investors) can only be resolved with the passage of time. Some selected country average P/E ratios appear in Table 5.2. You can see Japan’s P/E ratio has trended down.
There are two additional factors explaining the P/E ratio. The above formula shows that the P/E ratio is negatively related to the firm’s discount rate.
We have already suggested that the discount rate is positively related to the stock’s risk or variability. Thus, the P/E ratio is negatively related to the stock’s risk. To see that this is a sensible result, consider two firms, A and B, behaving as cash cows. The stock market expects both firms to have annual earnings of $1 per share forever. However, the earnings of firm A are known with certainty while the earnings of firm B are quite variable. A rational stockholder is likely to pay more for a share of firm A because of the absence of risk. If a share of firm A sells at a higher price and both firms have the same EPS, the P/E ratio of firm A must be higher.
The second additional factor concerns the firm’s choice of accounting methods. Under current accounting rules, companies are given a fair amount of leeway. For example, consider inventory accounting where either FIFO or LIFO may be used. In an inflationary environment, FIFO (first in–first out) accounting understates the true cost of inventory and hence inflates reported earnings. Inventory is valued according to more recent costs under LIFO (last in–first out), implying that reported earnings are lower here than they would be under FIFO. Thus, LIFO inventory accounting is a more conservative method than FIFO. Similar accounting leeway exists for construction costs (completed-contracts versus percentage-of-completion methods) and depreciation (accelerated depreciation versus straight-line depreciation).
As an example, consider two identical firms, C and D. Firm C uses LIFO and reports earnings of $2 per share. Firm D uses the less conservative accounting assumptions of FIFO and reports earnings of $3 per share. The market knows that both firms are identical and prices both at $18 per share. This price-earnings ratio is 9 ($18/$2) for firm C and 6 ($18/$3) for firm D. Thus, the firm with the more conservative principles has the higher P/E ratio.
This last example depends on the assumption that the market sees through differences in accounting treatments. A significant portion of the academic community believes that the market sees through virtually all accounting differences. These academics are adherents of the hypothesis of efficient capital markets, a theory that we explore in great detail later in the text. Though many financial people might be more moderate in their beliefs regarding this issue, the consensus view is certainly that many of the accounting differences are seen
through. Thus, the proposition that firms with conservative accountants have high P/E ratios is widely accepted.
This discussion argued that the P/E ratio is a function of three different factors. A company’s ratio or multiple is likely to be high if it has many growth opportunities, it has low risk, and it is accounted for in a conservative manner. While each of the three factors is important, it is our opinion that the first factor is much more so. Thus, our discussion of growth is quite relevant in understanding price-earnings multiples.
STOCKMARKET REPORTING
The Wall Street Journal, the New York Times, or your own local newspaper provides useful information on a large number of stocks in several stock exchanges. Table 5.3 reproduces what has been reported on a particular day for several stocks listed on the New York Stock Exchange. In Table 5.3, you can easily find the line for General Electric (i.e., “GenElec”). Reading left to right, the first two numbers are the high and low share prices over the last 52 weeks.
For example, the highest price that General Electric traded for at the end of any particular day over the last 52 weeks was $6050. This is read as 60 and the decimal . The stock symbol for General Electric is GE. Its annual dividend is $0.55. Most dividend-paying companies such as General Electric pay dividends on a quarterly basis. So the annual dividend is actually the last quarterly dividend of multiplied by 4 (i.e., .138 ϫ 4 ϭ $0.55).
Some firms like GenenTech do not pay dividends. The Div column for GenenTech is blank. The “Yld” column stands for dividend yield. General Electric’s dividend yield is the current annual dividend, $0.55, divided by the current closing daily price, which is $5663 (you can find the closing price for this particular day in the next to last column). Note that $0.55/5663 Х 1.0 percent. The next column is labeled PE, which is the symbol for the price-earnings ratio. The price-earnings ratio is the closing price divided by the current earnings per share (based upon the latest quarterly earnings per share multiplied by 4). General Electric’s price-earnings ratio is 51. If we were financial analysts or investment bankers, we
would say General Electric “sells for 51 times earnings.” The next column is the volume of shares traded on this particular day (in hundreds). For General Electric, 18,305,100 shares traded. This was a heavy trading day for General Electric. The last columns are the High, the Low, and the Last (Close) share prices on this day. The “Net Chg” tells us that the General Electric closing price of $5663 was lower than its closing price on the previous day by 144. In other words, the price of General Electric dropped from $5807 to $5663, in one day.
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