Dell

ADDITIONAL MEASURES OF RELATIVE VALUE

The best-known measure of relative value for common stock is the price/earnings ratio or the earnings multiplier because it is derived from the divided growth model and has stood the test of time as a useful measure of relative value. Although not rejecting the P/E ratio analysis have begun to calculate three additional measures of relative value forcommon stocks – the price book value ratio, the price/cash flow ratio and the price/sales ratio. In this section, each of these valuation ratios is discussed and demonstrated.

PRICE BOOK (P/BV) VALUE RATIO
The price-to-book-value ratio (P/BV) has gained prominence because of the studies by Fama and French and several subsequent authors. The rationale is that book value can be a reasonable measureof value for firms. Also, individual firms that have consistent accounting practice (for example, firms in the same industry) can be meaningfully compared. Notably, this measure can apply to firms with negative earnings or even negative cash flows. You should not attempt to compare this ratio for firms with different levels of hard assets – that is don’t compare a heavy industrial firm to aservice firm.
The annual P/BV ratios for Walgreen, its industry, and the market are in Table 20.4 along with the ratio of the company P/BV ratio relative to its industry and relative to the market ratio. In this instance, the major variable that should cause a difference in the P/BV ratio is the firm’s return on investment (ROI) relative to its cost of capital (its WACC). Assuming that most firmsin an industry have comparable WACCs, the major differential should be the firm’s ROI because the larger the ROI – WACC difference, the greater the justified P/BV ratio. We will consider this in the subsequent section on EVA.
As shown in Figure 20.5, the P/BV ratios for the three components have increased from about 1.5-2.00 to 4.0-4.5. as shown in Figure 20.6, which contains a plot of relativevaluations ratios. Walgreen has experienced a larger increase in its P/BV ratio than its industry as indicated by its Co/Ind ratio that has gone from about 0.80 to about 0.90. This seems reasonable based upon the difference in ROE for the Co versus the industry.

In contrast, the Co/Mkt ratio for Walgreen has declined from about 1.18 to about 0.83 at the end of the period. This latter trendis interesting because the ROE for Walgreen has consistently been greater than for the S&P 400 until 1995 when the ROE for the S&P 400 rose substantially. One must questions whether this declining trend in the Co/Mkt ratio its because the beginning relationship was too high.

FIGURE 20.5

FIGURE 20.6

FIGURE 20.7

PRICE / CASH FLOW (P/CF) Ratio
As noted in Chapter 12 the price / cashflow ratio has grown in prominence and use because many observers contend that a firm’s cash flow is less subject to manipulation than its earnings per share and because cash flows are widely used in the present value of cash flow models discussed earlier. An important question is: which of the several cash flow specifications should an analyst employ? In this analysis, we use the EBITDA cash flowmeasure equal to net income plus interest, depreciation, and taxes because this cash flow measure can be derived for both the retail drugstore industry and the market. Although it is certainly possible to employ any of the other cash flow measures discussed a demonstration using this measure should provide a valid comparison for learning purposes.
The time – series graph of the P/CF ratios inFigure 20.7 shows a general increase for Walgreen and its industry from about 7 times in 1977 to almost 20 times in 1997, while the market P/CF ratio went from 5 times to 12 times. Notably, although the absolute value of the ratios increased, the graphs in Figure 20.8 show that Walgreen P/CF ratios relative to its industry experienced an overall decline from 0.84 and a high of 1.40 to an er ding...