Question

Estimate multiples based on the following: High-growth period = 6 years, net income of $175 on sales of $1,350, with book value of equity of $1,125. During the high-growth period, the payout ratio will be 15%, and the firm’s beta of 1.25, risk-free rate of 2% and market risk premium of 5% will remain constant. After the 6-year high-growth period, the growth rate in earnings will drop to 3%. Determine the company’s P/E, PEG, Price to Book Value and Price to Sales ratios.

Answer 1

we have

net income since it is mentioned that these are estimates, this income is a future income(E1)=175

sales=1350

BV of equity=1125

High growth (G)=6%

beta=1.25

risk-free return (Rf)=2%

MRP=5%

required return (Re )as per CAPM=Rf+MRP*Beta=2+5*1.25=8.25%

constant growth (g)=3%

dividend payout ratio(DPR)=15%

dividend(D1)=DPR*E=.15*175=26.25

first of all, we need to find out the price as follows

Price= PV of all future cash flows (dividends)

since in this QUS, NO DATA IS GIVEN REGARDING NO. OF SHARES SO WE CANT CALCULATE EPS AND DPS AND PRICE BUT SINCE WE ARE WORKING WITH EARNINGS AND TOTAL DIVIDENDS WE WILL GET MARKET CAPITALISATION INSTEAD OF PRICE which is sufficient to calculate THE RATIOS REQUIRED IN THE QUS.

we have to streams of cash flows

1st is from year 1 to 6 starts with D1=26.25

and second is year 7 to forever starting with=D7=D6*1.03=26.25*1.06^5*1.03=36.18

for calculating PV of the 1st stream(PV1), there are different methods but simplest of them is using Ex growth Re i.e. Re'

Re'=Re/1+G=(1.0825/1.06)-1=2.12264%

now PV1=26.25*(((1-1.02122264^(-6))/.0212264)/1.06=138.14

now to calculate PV of stream 2(PV2) since the growth is constant forever we will use Gordon's growth formula which is

P(t-1)=D(t)/(Re-g)

where P(t-1)= price at time t-1

D(t)= dividend at time t

hence P6=D7/(Re-g)=36.18/(.0825-.03)=689.14

PV2=689.14/1.0825^6=428.29

Market cap. = PV1+PV2=138.14+428.29=566.43

now,

P/E ratio = Price/EPS=(price *No. of shares)/EOS*No.of shares)=Market cap./E=566.43/175=3.23

PEG ratio=(P/E ratio)/growth rate

for the first 6 years, it is =3.23/6=.539

for 7th year onwards it is=3.23/3=1.0766

price to book value=566.43/1125*100=50.35%

Price to sales =566.43/1350=41.95%