PHB-Solution Chapter 7
...equity is 25 percent. Q.4: Given the information used above and the revised market expectation of the firm’s long-term average return on equity equal to 20 percent while looking at the appropriate Manufactured Earnings’ stock price, a rearrangement of the stated price to book ratio formula in terms of the market price seems to be essential. Using the assumption stated above The Manufactured Earnings’ stock price is equal to $10 using the assumption of a long-term average return on equity equal to 20 percent. Q.5: Applying changes of book value growth rate to 12 percent per year, and the ROE of the incremental book value being only 15 percent, it is necessary to calculate the new market price in order to quantify the change in market-to-book ratio using the market price formula stated above. Using the market to book ratio formula Based on the changed assumptions the market to book ratio decreased to 1. Q.7: A company's P/E ratio is computed by dividing the current market price of one share of a company's stock by that company's per-share earnings. A company's per-share earnings are simply the company's after-tax profit divided by number of outstanding shares. Companies expected to grow and have higher earnings in the future should have a higher P/E than companies in decline. For example, if a company has a lot of products in the pipeline, an investor wouldn't mind paying a large multiple of its current earnings to buy the stock. The company will have a large P/E. because of its potential to grow quickly. A company’s market to book ratio is calculated by dividing market price by book value. The market price is the price as determined dynamically by buyers and sellers in an open market. In simplest terms, book value is Assets less Liabilities. A company with a high amount of fixed assets stated in its balance sheet is likely to have a low market to book ratio whereas a company with a high amount of intangible assets has a rather high market to book value. a. high PE and a low market-to-book ratio One reason for a low market to book ratio can be a high amount of fixed asset. A reason for a high PE might be expected high future earnings or a large investment in research and development of new products. So trying to find a company with these characteristics leads to an industry that is already established but still has the potential to grow. The sector Transportation has a rather low price to book ratio sector average (3.29) with an average P/E of 23.59. Taking a closer look at this section, the airline and railroad industry show a high P/E compared to a rather low market to book ratio (Airline 34.35 / 2.43; Railroad 22.57 / 1.62). Both industries are already developed and have a large amount of assets compared to a high investment in development of new products. b. high PE and a high market-to-book ratio A high PE can be based on the expectation of high future earnings generated by new products or services. A high price to book ratio is an indicator for comparable low mount of fixed and a high amount of intangible assets e.g. knowledge. The sector Technology has a very high sector average P/E (28.07) with a remarkable market to book ratio average (5.15). The technology sector is dominated by computer and software industry. Computer Services and Software & Programming show very high figures in both, P/E and market to book ratio (Computer Services 45.52 / 7.58; Software & Programming 27.53 / 5.78). The potential revenue of these companies will be generated by their intellectual property without the need of a high amount in fixed assets. Google might be the best example with a P/E of 91.65 and a market to book ratio of 18.27. c. low PE and a low market-to-book ratio Industries that decline tend to consist of companies that have a low P/E due to the end-stage of their life cycle and declining expectation of future income. The growth opportunity is rather low and most of the earnings where made years ago. The amount of fixed assets tends to be very high because of the advanced stage and time of business operation. Some industries of the sector Basic material seem to fulfil these characteristics. Not all of them do because of a comparable normal average sector P/E of 20.57 and a rather low market to book ratio average of 3.00. Several industries like Iron&Steel with a very low P/E of 8.10 and a market to book ratio of 2.01 defiantly show these characteristics. Every industry in the basic material sector has a rather low price to book ratio which is the reason for the low sector average but other industries in the same sector have a comparable high P/E e.g. Gold&Silver with a P/E of 39.63. d. low PE and a high market-to-book ratio Most of the companies with a rather low P/E are already established and have been operating their bu...