International Financial Markets

Comparing PEG Ratios and Determinants of Valuation

Firms with lower returns on equity (ROE) or lower payout ratios tend to have lower PEG ratios, making them appear more undervalued compared to firms with higher ROE and payout ratios. When comparing these ratios, it is important to control for differences in growth potential, risk, and payout ratio.

One way to do this is by using regression analysis to relate the PEG ratios of the firms being compared to measures of growth potential, risk, and payout ratio. The comparable firms in this analysis can be defined narrowly as firms that closely resemble the firm being valued, more expansively as firms in the same sector, or broadly as all firms in the market.

When running these regressions, it is important to consider that the independent variables are correlated with each other, and the relationship is both unstable and likely to be nonlinear. To address this, especially when the sample contains firms with varying levels of growth, you can transform the growth rate to make the relationship more linear.

A scatter plot of the data can be helpful in visualizing the relationship.

With lower costs of capital, firms should trade at much higher multiples of EBITDA.

Other things remaining equal, firms with higher expected growth should trade at much higher multiples of EBITDA.

Third, the book value of equity can become negative if a firm has a sustained string of negative earnings reports, leading to a negative price-book value ratio.

The price-to-book ratio is computed by dividing the market price per share by the current book value of equity per share.

The price-to-book ratio is computed by dividing the market price per share by the current book value of equity per share.

The price-to-book ratio is computed by dividing the market price per share by the current book value of equity per share.

The price-to-book ratio is computed by dividing the market price per share by the current book value of equity per share.

You compute book value of equity per share. In particular, Book value of equity per share is the current book value of equity per share.

If there are multiple classes of shares outstanding, the price per share can be different for different classes of shares, and it is not clear how the book equity should be apportioned among shares.

While the multiple is fundamentally consistent—the numerator and denominator are both equity values—there is a potential for inconsistency if you are not careful about how you compute book value of equity per share.

You should not include the portion of the equity that is attributable to preferred shares.

equity per share. In particular, ferred stock in computing the book value of equity, since the market value-If there are multiple classes of shares outstanding, the price per share can be different forequity refers only to common equity.=If there are multiple classes of shares outstanding, the price per share can beSubstituting for DPS EPS (Payout ratio), the value of the equity c■different classes of shares, and it is not clear how the book equity should be apportioned among1 1different for different classes of shares, and it is not clear how the book equityshares. Some of the problems can be alleviated by computing the price-to-book ratioshould be apportioned among shares.-You should not include the portion of the equity that is attributable to pre- ferred stock in×EPS Payout ratioing the total market value of equity and book value of equity, rather than pYou should not include the portion of the equity that is attributable to pre-■ 1=Pcomputing the book value of equity,

Companies use the composite market value of all classes of common stock in the numerator, conversion options (in bonds and preferred stock), and add them to the market value of equity once every year for European companies. While most analysts use the most current and the composite book value of equity in the denominator, you would still ignore the book value of equity before computing the price to book value ratio.

There are some who use the average over the previous year multiplied by the P ROE Payout ratio preferred stock for this computation. 0 = =PBV the book value of equity at the end of the latest financial year. Consistency demands that you use the same measure of book equity for all firms in your sample. The second measurement issue relates to the book value of equity, which as an account-Because it is The BV provides a relatively stable, intuitive measure of value and more difficult.

The problem concerns the value of options outstanding. Teching measure gets updated infrequently—once every quarter for U.S. companies and that can be compared to the market price. comparability. Given reasonably consistent accountingcally, you would need to compute the estimated market value of managemeonce every year for European companies. While most analysts use the most current standards across firms, P/BV ratios can be compared across similar firms for signs of under- orThe PBV ratio is an increasing function of the return on equitybook value of equity, there are some who use the average over the previous year orover-valuation. applicability. Even firms with negative earnings, which cannot be valued usingand the growth rate, and a decreasing function of the riskiness ofthe book value of equity at the end of the latest financial year. Consistency demandsprice-earnings ratios, can be evaluated using P/BV ratios.This formulation can be simplified even further by relating gr

You use the same measure of book equity for all firms in your sample. The BV (book value) may not carry much meaning for service and technology firms that do not have significant tangible assets. BVs, like earnings, are affected by accounting decisions. When accounting standards vary widely across firms, the P/BV (price-to-book value) ratios may not be comparable. The BV of equity can become negative if a firm has a sustained string of negative earnings.