Page 12 - FINAL CFA II SLIDES JUNE 2019 DAY 8

LOS 31.g: Describe fundamental factors that influence READING 31: MARKET-BASED VALUATION: PRICE AND
alternative price multiples and dividend yield.
LOS 31.h: Calculate and interpret the justified price-to- ENTERPRISE VALUE MULTIPLES
earnings ratio (P/E), price-to-book ratio (P/B), and price- MODULE 31.4: EV AND OTHER ASPECTS
to-sales ratio (P/S) for a stock, based on forecasted
fundamentals.

If you know the formula,
you know the
fundamental factors….

The justified P/E ratio is:
• Positively related to the growth rate of expected cash flows, whether defined as dividends or free cash flows, all else equal.
• Inversely related to the stock’s required rate of return, all else equal.

Justified P/B Multiple where:
ROE = return on equity
Per sustainable growth relation: r = required return on equity
• g = ROE × b; and but b = proportion of earnings retained
g = expected growth rate in dividends and earnings
• ROE = E / B (meaning E = B × ROE B 0 = Book value (of equity)
0
1
0
1
/ B 0 We can then use fundamental
/ B 0 forecasts of ROE, r, and g to
find a value for this ratio.
Observations:
• Positively related to ROE increases, all else equal.
• Inversely related to r (lower r = larger spread between ROE and r), all else equal, the higher the P/B ratio.

EXAMPLE: Calculating justified P/B ratio: A firm’s ROE is 14%, its required rate of return is 8%, and its expected growth
rate is 4%. Calculate the firm’s justified P/B based on these fundamentals.