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Pablo Fernandez

IESE Business School, University of Navarra

Ch27 PER, P to Book and growth

Price to Earnings ratio, Value to Book ratio and Growth

Pablo Fernandez, Professor of Finance


IESE Business School, University of Navarra
e-mail: fernandezpa@iese.edu and pfernandez@iese.edu
Camino del Cerro del Aguila 3. 28023 Madrid, Spain
November 11, 2013

The PER is the most commonly used parameter in the stock market. The PER is the result of dividing
the equity market value by the companys profit after tax.
The PER depends on a number of factors, some of which are out of the companys control, such as
variations in interest rates, and others are intrinsic to the company, such as its risk, its growth and the return on
its investments. The PER increases, ceteris paribus, if interest rates fall, if the companys risk decreases, and if
the companys profit after tax increases. The PER increases with growth if the return on the companys
investments is greater than the required return to equity.
The relationship between share prices (their market value for listed companies) and their book value is
the subject of considerable study by financial analysts. We analyze the relationship between the two parameters
in several companies and different countries. We also analyze the influence of the PER and on this relationship.

1. Evolution of the PER on the international stock markets


2. Growth value and PER due to growth
3. Market value and book value on the North American stock market
4. Market-to-book ratio on the international stock markets
5. Market-to-book ratio and interest rates on the North American stock market
6. Relationship between the market-to-book ratio and the PER and the ROE
7. Equity book value may be negative: the case of Sealed Air

Appendix 1. Splitting the PER: franchise factor, growth factor, interest factor and risk factor
1. PER, franchise factor and Growth Factor
2. PER*, franchise factor* and Growth Factor
3. PER, Interest Factor and Risk Factor
4. Value generation over time in companies with growth
5. Influence of growth on the franchise factor and on the Growth Factor
6. Influence of the ROE on the franchise factor
7. Influence of the required return to equity on the Franchise Factor and on the PER
8. Splitting the PER. Proof.

Tables and figures are available in excel format with all calculations in:
http://web.iese.edu/PabloFernandez/Book_VaCS/valuation%20CaCS.html

CH27- 1

Electronic copy available at: http://ssrn.com/abstract=2212373

Pablo Fernandez
IESE Business School, University of Navarra

Ch27 PER, P to Book and growth

The PER is the most commonly used parameter in the stock market. The PER is the result of dividing
the equity market value by the companys profit after tax.
PER = Equity market value / profit after tax = Price per share / earnings per share
Example. On 6 October 2000, General Electric had 9.901 billion shares outstanding. The price of one
share was 59.4375 dollars. The price of all the shares (market capitalization) was therefore 588.52481 billion
dollars. The profit after tax in 1999 was 10.396679 billion dollars and the earnings per share was 1.05 dollars.
Therefore, General Electrics PER on 6 October 2000 was 56.607 (59.4375/1.05 = 588.52481/10.396679). The
earnings per share forecast for 2000 was 1.24. Therefore, General Electrics PER on 6 October 2000 on the
basis of the expected earnings per share for 2000 was 47.93 (59.4375/1.24).
1. Evolution of the PER on the international stock markets
Figure 1 shows the evolution of the PER of two leading telecommunications companies in their
respective countries: Telefnica in Spain and British Telecom in the United Kingdom. In the case of Telefnica,
it can be seen that the PER peaked in February 1994 and then fell until October 1995, when it started to rise
again. As we shall see in Figure 3, these variations were basically due to variations in the interest rates: when
interest rates fall, the PER rises; and when interest rates rise, the PER falls.
Figure 1 also shows the boom experienced by the telecommunications companies during 1999 particularly at the end- and the beginning of 2000. In this period, all stocks related with the telecommunications
world and the new Internet era were rewarded significantly on the stock market. The impressive rise in these
companies share price was due to the investors expectations which, as can be seen, shifted down to more
reasonable levels after February 2000.
Figure 2 shows the evolution of the PER of three of the largest North American companies.
Particularly noteworthy is the case of Cisco Systems, whose PER has been far above the rest. Cisco attained a
maximum PER of 236.05. One can also see the fall of this companys share price after February 2000.
Figure 1. Evolution of the PER of Telefnica and British Telecom. Source: Datastream
60

PER

TELEFONICA

50

BRITISH TELECOM

40
30
20
10
0
12-89

100

12-91

12-93

12-95

12-97

12-99

12-01

12-03

12-05

12-07

12-09

12-11

Figure 2. Evolution of the PER of GE, Microsoft and Cisco. Source: Datastream
PER

GE
MICROSOFT
CISCO

80
60
40
20
0
12-90

12-92

12-94

12-96

12-98

12-00

12-02

12-04

12-06

12-08

Figure 3, which shows the evolution of the average PER of the Spanish stock market and the interest
rate paid on 10-year public debt, confirms that when interest rates fall significantly, the PER rises, and viceversa. Figure 4 shows the evolution of the average PER of the Spanish, North American and English stock
markets. Note that the Spanish stock markets PER equaled that of the other two stock markets at the end of
1993, then fell behind and subsequently surpassed the English stock market at the end of 1996 and equaled the
North American stock market in 1997 and 1998.

CH27- 2

Electronic copy available at: http://ssrn.com/abstract=2212373

Pablo Fernandez
IESE Business School, University of Navarra

Ch27 PER, P to Book and growth

Figure 5 shows the ratio between the average PER of the United States stock market and the S&P 500.
As PER= price/profit after tax, it is logical that the PER follows approximately the evolution of the S&P 500,
which is an index that reflects the prices of the shares included in it. In this case, this ratios denominator breaks
this trend at certain times.
Figure 3. Evolution of interest rates and the average PER of the Spanish stock market. Source: Datastream
14

10yearinterestrate(%)

Interest rate

26

PER

PER Spain

12

22

10

18

14

10

4
2
12-91

6
12-93

12-95

12-97

12-99

12-01

12-03

12-05

12-07

12-09

12-11

Figure 4. Evolution of the average PER of the Spanish, English and United States stock markets. Source:
Datastream
30

Spain
UK
U.S.

PER

25
20
15
10
5
12-90

12-92

12-94

12-96

12-98

12-00

12-02

12-04

12-06

12-08

12-10

12-12

S&P 500

1600

Figure 5. S&P 500. Evolution and average PER. Source: Datastream


35

PER

1400

30
25

PER USA

1200

S&P 500

1000
800

20

600
400

15
10
12-89

200
0
12-91

12-93

12-95

12-97

12-99

12-01

12-03

12-05

12-07

12-09

12-11

2. Growth value and PER due to growth


To quantify the influence of expected growth (g) on the share price and the PER, we can calculate the
price that the share would have if the company did not grow, that is, if the previous years profit after tax was
constant and the company distributed it entirely as dividends. The shares price if the company did not grow is
the earnings per share (EPS) divided by the required return to equity:
P no growth= EPS / Ke
We can say that the share price is the price it would have if there was no growth (P no growth) plus the
growth value1:

The value of the growth is also called the present value of the growth opportunities.

CH27- 3

Pablo Fernandez
IESE Business School, University of Navarra

Ch27 PER, P to Book and growth

P = P no growth + Growth value


Example. GEs share price on 6 October 2000 was $59.4375. The earnings per share in 1999 was
1.05. If the required return to equity was 11%, the no growth price of GEs share would be $9.545 (1.05/0.11),
and the growth value would be $49.89 (59.4375 - 9.545). Consequently, 16% (9.545/59.4375) of the value of
GEs share was due to the profit after tax already attained by the company (P no growth) and 84%
(49.89/59.4375) was due to the expected growth (growth value). By way of reference (see Appendix 2), on
average, 47.5% of the value of the companies included in the Euro Stoxx 50 in May 2001 was due to the profit
after tax already attained by the companies (P no growth) and 52,5% corresponded to the expected growth
(growth value).
We can perform the same breakdown with the PER and consider it as the sum of the PER that the
company would have if the incremental PER due to growth did not grow any further.
PER = PERno growth+ PERgrowth
As the PER is the price per share divided by the earnings per share, this gives:
PERno growth= 1/Ke
PERgrowth = Growth value / EPS
Figure 6 shows that in the nineties the PER due to growth was almost 70% of the PER in early 1992
and at the end of 1999.
Figure 6. US Stock Market. PER due to growth as a percentage of PER, and PER.
Sources. PER USA MSDW. PER due to growth: authors data
70%

PERgrowth

PERgrowth

60%

PER U.S.

35 PER
U.S.

30

50%
25
40%
30%

20

15
20%
01-91 01-92 01-93 01-94 01-95 01-96 01-97 01-98 01-99 01-00 01-01 01-02 01-03 01-04 01-05

Market Value and Book Value


The relationship between share prices (their market value for listed companies) and their book value is
the subject of considerable study by financial analysts. We will analyze the relationship between the two
parameters in several companies and different countries. We will also analyze the influence of the PER and on
this relationship.
3. Market value and book value on the North American stock market
Figure 7 shows the evolution of the market-to-book ratio of the US stock market and the S&P 500 in
recent years. Obviously, both lines move in parallel: when stock prices rise, the shares market-to-book ratio
also rises and vice-versa. However, it is important to remember that the equity book value increases when there
are capital increases, when companies retain earnings and also when assets appreciate.
Figure 8 shows the evolution of the market-to-book ratio (E/Ebv) of Coca Cola and Pepsico. It is
interesting to see that although Coca Colas ratio has been markedly higher during the period 1991-2001, the
two companies ratios have been converging since mid-1998 and had almost met by 2001.
Figure 9 shows the evolution of the ratio of three of the worlds largest companies: General Electric,
Microsoft and Cisco. Note the enormous market-to-book ratio of Cisco in the second half of 1999 and 2000,
coinciding with the Internet Speculative Bubble. In the first months of 2000, the market-to-book ratio (E/Ebv)
for Cisco was higher than 40.

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Pablo Fernandez
IESE Business School, University of Navarra

Ch27 PER, P to Book and growth

Figure 7. Evolution of the average market-to-book ratio of the US stock market and evolution of the S&P
500. Sources: Morgan Stanley and Datastream
1600
1400

S&PCOMP(PI)

4,5

US- Market/Book Value (E/Ebv)

1200

1000
S&P 500
800

3,5

600

2,5

400

200

1,5

0
12-90

3 E/Ebv

1
12-92

12-94

12-96

12-98

12-00

12-02

12-04

12-06

12-08

12-10

12-12

Figure 8. Evolution of the market-to-book ratio of Coca Cola and Pepsico. Source: Datastream
25
PEPSICO
20

COCA COLA

E/Ebv 15
10
5
0
12-90

12-92

12-94

12-96

12-98

12-00

12-02

12-04

12-06

12-08

12-10

12-12

Figure 9. Market-to-book ratio of General Electric, Microsoft and Cisco. Source: Datastream
GENERAL ELECTRIC
MICROSOFT
CISCO SYSTEMS

20
15

E/Ebv 10
5
0
12-90

12-92

12-94

12-96

12-98

12-00

12-02

12-04

12-06

12-08

12-10

12-12

Figure 10. Evolution of the average market-to-book ratio of the US, UK and Spanish stock markets.
Source: Datastream
5
SPAIN Market/Book
US Market /Book
4
UK Market/Book
3
E/Ebv
2
1
0
12-90

12-92

12-94

12-96

12-98

12-00

12-02

12-04

12-06

12-08

12-10

12-12

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Pablo Fernandez
IESE Business School, University of Navarra

Ch27 PER, P to Book and growth

4. Market-to-book ratio on the international stock markets


Figure 10 shows the evolution of the market-to-book ratio (E/Ebv) in the United States and compares it
with the evolution of the same ratio in the United Kingdom and Spain. As can be seen, during the period
between 1991 and 1999, the North American market had the highest ratio and Spain the lowest ratio, although it
was above the British ratio in 2000 and 2001. The market-to-book ratio grew enormously in all three countries
until December 1999, and then fell in 2000 and 2001, following the general trend of the world stock markets.
5. Market-to-book ratio and interest rates on the North American stock market
Share prices and interest rate variations are closely linked. Consequently, it is to be assumed that
shares market-to-book ratio will also be related with interest rates. Figure 11 enables this ratios evolution to
be compared with the evolution of the interest rates. It can be seen that, historically, when interest rates have
risen, the market-to-book ratio has fallen, and when interest rates have fallen, as happened after 1995, the
market-to-book ratio has increased.
Figure 11. Evolution of the average market-to-book ratio of the US stock market and the long-term
interest rates. Source: Morgan Stanley and Datastream
5,5

E/Ebv USA

30-year yield

4,5

3,5

30-year

E/Ebv 3

5 yield (%)

2,5

1,5
1
12-90

2
12-92

12-94

12-96

12-98

12-00

12-02

12-04

12-06

12-08

12-10

12-12

6. Relationship between the market-to-book ratio and the PER and the ROE
The market-to-book ratio (E/Ebv) is closely related with the Price-to-Earnings Ratio (PER) and the
return on equity (ROE). It can be readily verified by means of a simple algebraic operation that the E/Ebv ratio
is equal to the PER multiplied by the ROE:
[1]

E
Market value Market value
Net income

x
= PER x ROE
Ebv Book Value
Net income
Book Value

Table 1 shows the values of these three ratios for British Telecom, General Electric, Microsoft and
Cisco in recent years. The reader can see that the previous equation: E/Ebv = PER x ROE, is met in all cases.
Table 1. Evolution of the E/Ebv, PER and ROE of British Telecom, General Electric, Microsoft and
Cisco. Source: Datastream and own data.
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
ROE (%) 16,4 19,7 17,4 10,0 13,6 14,4 15,7 18,7 15,8 20,0 13,0 3,1
10,6 10,5 12,5 12,3 11,5 10,1 12,1 16,7 27,3 29,4 26,5 NA
British Telecom. PER
MV/BV
1,7 1,8 2,1 2,2 2,1 1,8 2,5 3,4
4,0
4,2 3,4 -36,8
ROE (%) 19,9 12,2 20,1 16,7 17,9 22,2 23,4 23,8 23,9 25,2 25,2 25,0
Gen. Electric
PER
14,1 15,2 16,1 18,5 16,4 24,4 23,6 31,1 34,5 43,3 37,5 26,2
MV/BV
2,7 2,8 2,9 3,4 2,9 4,2 4,9 6,5
7,6
9,3 8,6 5,8
ROE (%) 30,4 34,3 32,3 29,4 25,8 27,3 31,8 35,3 28,7 28,4 22,8 11,1
Microsoft
PER
36,6 41,5 31,9 23,8 28,9 33,3 50,9 53,2 62,5 62,3 34,0 55,4
MV/BV
9,1 10,5 7,7 5,3 6,7 8,3 11,9 12,2 14,9 13,6 7,1 6,2
ROE (%) 20,1 33,9 34,4 36,2 37,1 30,5 32,4 24,5 19,0 18,0 10,1 -8,2
Cisco Systems
PER
47,8 52,3 46,5 46,3 27,7 51,4 41,5 52,3 116,4 195,4 77,7 NA
MV/BV
6,6 10,3 11,6 10,9 7,2 10,3 10,0 9,7 14,2 16,3 9,7 4,7

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Pablo Fernandez
IESE Business School, University of Navarra

British Telecom.
Gen. Electric
Microsoft
Cisco Systems

ROE (%)
PER
MV/BV
ROE (%)
PER
MV/BV
ROE (%)
PER
MV/BV
ROE (%)
PER
MV/BV

2003
-401,3
7,6
5,9
22,2
15,2
2,9
17,1
27,3
4,2
10,9
35,8
3,3

2004
80,9
10,7
5,0
19,0
21,4
3,2
12,8
33,0
3,9
13,7
43,4
6,5

Ch27 PER, P to Book and growth

2005 2006 2007 2008 2009 2010 2011 2012


41,7 311,7 82,7 40,6 48,1 NA 234,0 588,5
12,6 10,8 14,0 10,9 4,3 6,8
8,8
9,4
4,6 11,1 6,2 3,8 58,4 -3,8
7,5 12,8
15,1 15,0 18,6 19,2 16,6 9,4
9,8 12,1
22,8 21,3 18,2 15,5 6,2 14,5 17,6 15,5
3,5
3,0 3,1 3,4 1,0 1,4
1,9
1,7
21,2 29,5 32,5 49,3 50,0 36,7 42,4 36,6
28,6 22,6 25,0 16,2 10,6 15,4 11,8 10,9
5,9
6,8 8,9 7,2 4,4 5,3
4,1
3,8
22,7 24,3 24,4 24,6 20,4 14,6 16,6 14,2
23,6 20,7 28,7 18,2 13,5 22,8 16,1 17,6
4,9
4,5 5,3 4,0 2,6 3,0
2,5
2,1

Figure 12 shows the evolution of the average ROE of the US, UK and Spanish stock markets. Note
that the average ROE of the Spanish stock market has been less than the ROE of the American and British stock
markets until 2000. However, in 2001 it was the highest of the three.
Figure 13 shows the evolution of the ROE of Coca Cola and Pepsico. As can be seen, Coca Colas
ROE has been markedly higher than Pepsicos until the end of 1999. The fall in Coca Colas ROE in 1998,
1999 and 2000 is surprising.
Figure 12. Evolution of the average ROE of the US, UK and Spanish stock markets. Source: Datastream

Figure 13. Evolution of the ROE of Coca Cola and Pepsico. Source. Datastream

Figure 14. Return on equity (ROE) of General Electric, Microsoft and Cisco. Source. Datastream

CH27- 7

Pablo Fernandez
IESE Business School, University of Navarra

Ch27 PER, P to Book and growth

Figure 14 shows the evolution of the ROE of three of the worlds largest companies. Ciscos ROE was
negative after the first quarter of 2001 as a consequence of the losses reported by the company. It is also
interesting to see the cyclical evolution of Microsofts ROE and the growth of General Electrics ROE.
The relationship between the equity market value (E) and book value (Ebv) depends on only three
factors: ROE, required return to equity (Ke), and expected growth of dividends (g).
ROE - g
E
[2]

Ke - g
Ebv
Return
on Equity

ROE

Return
on Equity

ROE

Price/
Book Value
Growth

g
Price / earnigs

E / Ebv

Risk-free rate

ratio

PER x ROE

RF

PER

Required return
to equity

Ke
Risk of
investment

Fama and French (1992) show that, on average, the companies with lower PER and E/Ebv have higher
shareholder returns than the companies with higher PER and E/Ebv. In the period 1963-1990, there was quite a
strong relationship between the shareholder return and the market-to-book ratio. The authors divided the shares
into portfolios and the portfolios with lower market-to-book ratios had higher shareholder returns. Table 2
shows this effect.
Table 2. Fama and French (1992). Relationship between market-to-book ratio and shareholder return.
Market-to-book ratio
Annual average shareholder return
Portfolio 1 (high)
5.9%
Portfolio 2
10.4%
Portfolio 3
11.6%
Portfolio 4
12.5%
Portfolio 5
14.0%
Portfolio 6
15.6%
Portfolio 7
17.3%
Portfolio 8
18.0%
Portfolio 9
19.1%
Portfolio 10 (low)
22.6%
7. Equity book value may be negative: the case of Sealed Air
Sealed Air Co. paid its shareholders a special dividend of 40 dollars per share in May 1989. In the
month prior to the special dividend, its share price had ranged between $44 and $46. The company had
8,245,000 shares outstanding. The special dividend meant paying $329.8 million (87% of the shares market
value). As the company only had $54 million in cash, it borrowed most of the funds required to pay the
dividend. After paying the dividend, the company had a negative equity book value of $160 million.
On the day after announcing the extraordinary dividend, there was a rush to buy the companys
shares2. The opening price was $53 per share, and it closed at $50.5 dollars, $4.38 above the previous day.
2

In the press release, the companys president said: the special dividend will enable the companys
shareholders to realize in cash a very significant portion of the companys value, while at the same time

CH27- 8

Pablo Fernandez
IESE Business School, University of Navarra

Ch27 PER, P to Book and growth

Subsequently, the new shares increased value and ended 1989 at $20.4. Figure 15 shows how the shares price
dropped after paying the dividend and its subsequent rise.
Figure 15. Share price of Sealed Air from 1987 to 1989, and from 1989 to 2000
Share price ($)
60

Share price ($)


300
250

50
40
30
20
10
d-86

d-87

d-88

200
150
100
50
0
d-89 d-90 d-91 d-92 d-93 d-94 d-95 d-96 d-97 d-98 d-99 d-00
d-89

The companys tremendous leverage was accompanied by a substantial increase in its efficiency ratios.
Sealed Air gave its shareholders a 290% return from April 1989 to December 1992, while the stock market
rose 36% during the same period. Before the special dividend, from December 1986 to April 1989, the
shareholder return was 6%, while the market return was 48%.
Table 3 shows that the shareholders equity was negative in 1989 due to the dividend payment. It can
also be seen the debt increased during that year to cover the dividend payment. The shareholders equity
became positive again in 1994. Sales, operating profit, and net income also grew during this period.
($ million)
Sales
Operating profit
Net income
Current assets
Inventories
Shareholder's equity
Long-term debt
Investments

1987
302.7
38.2
20.5
80.7
32.0
141.1
34.4
13.1

Table 3. Sealed Air. 1987 to 1997


1988 1989 1990 1991 1992 1993
345.6 385.0 413.3 435.1 446.1 451.7
43.6
53.7
67.4
69.5
72.2
74.1
25.3
7.2
11.4
16.2
20.8
27.4
96.0
86.7
22.3
18.5
29.4
33.8
36.2
25.9
25.6
28.3
28.3
32.0
162.3 -160.5 -131.6 -94.6 -66.3 -29.4
33.5 311.1 259.0 253.7 225.3 190.1
13.9
13.8
12.1
15.9
11.2
22.4

1994
519.2
83.9
31.6
15.8
38.3
11.0
155.3
29.9

1995
723.1
108.9
52.7
41.9
43.3
106.3
149.8
21.0

1996
789.6
130.1
69.3
58.9
42.3
186.6
99.9
17.0

1997
842.8
138.1
80.0
87.2
48.3
257.3
48.5
24.3

Founded in 1960, Sealed Air manufactured and sold a broad range of packaging products. One of its
most famous products was the plastic wrapping with air bubbles. Other products were self-sealing envelops,
paper for absorbing meat fluids for supermarkets, and plastic materials for packaging fragile goods.
When it announced the special dividend to the banks, the company found that many banks did not
want to lend money to a company with negative shareholders equity.
In spite of these problems, Sealed Air obtained a loan from Bankers Trust for $136.7 million (with the
possibility of increasing it to $210 million) at an interest rate of 11.5%3. It also issued $170 million in 10-year
subordinated bonds paying an interest rate of 12.625%. To finance the remaining $23.1 million, the company
realized short-term investments. The agreement with the banks also required that any proceeds from the sale of
assets should be used to pay back loans. In addition, Sealed Air would not be able to take out any additional
loans.
Commissions and other expenses associated with the special dividend amounted to $20.9 million.
After the special dividend, the companys management shifted the emphasis in its policies to new
priorities: 1) putting the customer first; 2) cash flow; 3) working capital focus; 4) innovation; and 5) earnings
per share.

maintaining their holding in it. Our strategy has always been to be market leader in packaging products. With
the present investments, we believe that the company has sufficient production capacity to satisfy the growing
demand for its products for several years without any significant additional investments. We also believe that it
is unlikely, in the present market circumstances, that we will find opportunities for major acquisitions at an
acceptable price that are consistent with our strategy. The special dividend is not a response to any takeover
offer.
3
The Bankers Trust prime rate plus 1.5%.

CH27- 9

Pablo Fernandez
IESE Business School, University of Navarra

Ch27 PER, P to Book and growth

The company implemented a new incentive plan for its managers. Before the recapitalization4, the
incentives were based on the earnings per share, then on the EBITDA (earnings before interest, tax,
depreciation and amortization), inventory level, level of accounts receivable, and working capital. The aim of
the new incentive plan was to focus the managers attention on the importance of generating cash flow. The
president explained this change in incentives as follows: In our company, our managers never had to worry
about the balance sheet and the company accepted the investments recommended by managers without demur.
By changing from earnings per share to EBITDA, we have focused our managers more on the cash flow. The
company also implemented a plan to enable employees to hold more shares in the company. In April 1989, the
employees had 7.9% of the companys shares; by March 1992, their holding had increased to 24.6%.
Figure 16 shows that the companys operating profit/sales ratios were higher than that of the industry.
It also shows the reduction in net working capital and the inventories/sales ratio after paying the dividend5.
Figure 16. Behavior of Sealed Air compared with the industry. Source: Wruck (1998)
40%

30%

14%

Sealed Air

Sealed Air
30%
Industry

20%

Operating profit/Sales

10%
85

86

87

88

89

90

0%
91

Industry

10%

92

Industry

12%
10%

20%

Sealed Air

8%
Net working capital/Sales
85

86

87

88

89

Inventories/Sales

6%
90

91

92

85

86

87

88

89

90

91

92

On 31 March 1998, the company merged with Cryovac, W.R. Grace & Co.s packaging products
division. The merged company continues to be called Sealed Air.
Not all leveraged recapitalizations have been as profitable for shareholders as Sealed Airs. Table 4
shows the shareholder return of 33 leveraged recapitalizations.
Table 4. Leveraged recapitalizations. Shareholder return in the year after the Leveraged Recap.
Source: Wruck (1998)
Annual return
Annual return
Company
Company S&P 500 difference
Company
Company S&P 500 difference
Sealed Air Corp
62.8%
10.8%
52.1%
Whittaker
-1.8%
10.6%
-12.3%
Holiday Corp
59.8%
5.5%
54.3%
Phillips-Van Heusen
-1.8%
5.2%
-7.0%
Holly Corp
40.8%
12.0%
28.8%
Triad Systems
-3.7%
0.3%
-3.9%
Shoney's
40.6%
11.8%
28.8%
Service Merchandise
-5.6%
8.4%
-14.0%
CUC International
39.5%
7.6%
31.9%
Swank Inc
-11.5%
6.1%
-17.6%
Barry Wright
31.8%
22.5%
9.4%
GenCorp
-19.5%
6.9%
-26.4%
Kroger
25.8%
13.0%
12.8%
WNS Inc
-28.0%
11.6%
-39.5%
Colt Industries
24.1%
8.5%
15.6%
Butler Manufacturing
-30.0%
-0.1%
-29.9%
Cleveland-Cliffs
22.8%
13.8%
9.0%
USG Corp
-35.3%
12.8%
-48.1%
Di Giorgio
18.8%
11.6%
7.2%
Interlake Corp
-36.2%
7.5%
-43.7%
FMC Corp
17.6%
9.4%
8.2%
Quantum Chemical
-38.5%
13.5%
-52.0%
Owens Corning
12.6%
10.5%
2.1%
Standard Brands Paint
-39.0%
13.2%
-52.1%
Vista Chemical
12.0%
10.5%
1.6%
Carter Hawley Hale
-44.0%
5.8%
-49.8%
Union Carbide
10.0%
12.1%
-2.0%
HBJ
-49.2%
6.4%
-55.6%
Optical Coating Lab
8.5%
5.7%
2.8%
Interco
-63.1%
13.9%
-77.0%
Goodyear
5.8%
8.4%
-2.6%
Bank Bldg Equip
-79.7%
3.7%
-83.5%
General Signal
5.3%
13.6%
-8.4%
Average
-1.5%
9.5%
-10.9%
The operations carried out as a defense measure against takeovers are in Italics

Recapitalization is the name given to the increase in the companys indebtedness as a result of the payment of
the special dividend.
5
Those readers interested in finding out more about the company can see the Harvard Business School cases 9294-122/3 Sealed Air Corporations Leveraged Recapitalization, written by Karen Wruck.

CH27- 10

Pablo Fernandez
IESE Business School, University of Navarra

Ch27 PER, P to Book and growth

Appendix 1. Splitting the PER: franchise factor, growth factor, interest factor and risk factor
The PER is the multiple of the profits at which the market values a companys shares. This multiple
basically depends on the markets expectations regarding the companys growth, profitability and risk. Growth
alone is not enough to give a high PER, the company must invest in projects having a return greater than the
cost of capital. In order to study in greater depth the factors that affect the PER, we shall split6 the PER into two
addends: the first is the PER the company would have if it did not grow and the second is the contribution made
by the companys growth to the PER, which in turn splits into a product of two factors: the Franchise Factor,
which measures the growths quality, and the Growth Factor. We shall see that for growth to contribute to the
PER, the company must invest in projects having a return greater than the cost of capital.
Further on, the PERs first addend is split into another two factors: the Interest Factor and the Risk
Factor. The Interest Factor is -approximately- the PER of a long-term Treasury bond. The Risk Factor depends
on the companys risk, which is defined as the required return to equity.
1. PER, franchise factor and Growth Factor
The PER can be split into two addends as follows (see the proof in 8):

PER

1
+ FF x G
Ke

FF =

ROE - Ke
ROE Ke

G=

g
Ke - g

The first addend, 1/Ke = 1/10% = 10, is the companys PER if it has no growth, regardless of the
return on its investments.
The second addend (FF x G) is the contribution made by growth to the PER. It consists of two
factors:
- the Growth Factor G, which basically depends on the companys growth.
- the franchise factor FF, which mainly depends on the difference between the return on investment
and the cost of capital employed. The franchise factor measures what we could call the growths quality,
understanding this to be the return above the cost of the capital employed.
This formula tells us that a companys PER is the PER of the no-growth company plus an extra
PER due to growth, which depends on the growth (G) and the quality of that growth (franchise factor).
We shall now apply this split to six companies.
Table A1 shows all six companies Growth Factor G and franchise factor FF. Obviously, the
companies that do not grow (company B and company C) have a Growth Factor of zero. The company that
grows most (company D with 8%) has the highest Growth Factor: 4.

PER
G
FF
G x FF

Table A1. PER, FF and G of six companies.


A
B
C
D
10.00
10.00
10.00
16.67
1.5
0
0
4
0
0
1.667
1.667
0
0
0
6.667

E
12.50
1.5
1.667
2.500

F
15.38
2.333
2.308
5.385

The companies investing in projects with a return equal to the cost of capital (company A and
company B) have a franchise factor of zero. The companies investing in projects with a return of 12%
(companies C, D and E) have a franchise factor of 1.667 and the company investing in projects with a return of
13% (company F) has a franchise factor of 2.308. The higher the return on investment, the higher the franchise
factor.
We have seen with these simple examples that growth alone is not enough to have a high PER:
growth is important, but only if the new investments have a return greater than the cost of capital (growth with
quality).
A word of caution: in the above examples, the PER has been calculated by dividing the shares price
today by next years expected profit. Very often, the PER is calculated by dividing the shares price today by
last years profit. In this case (as we shall see in the following section), the PERs breakdown is identical but
the expression of the franchise factor changes a little: all we have to do is add 1 and calculate the return on
investment (ROE) also with this years profit, instead of with next years profit.
6

This splitting of the PER is discussed in the article of Leibowitz and Kogelman (1992).

CH27- 11

Pablo Fernandez
IESE Business School, University of Navarra

Ch27 PER, P to Book and growth

2. PER*, franchise factor* and Growth Factor


We use the asterisk (*) to identify the PER* calculated by dividing the shares price today by this years
profit.
As PER * = P0 = E 0 and PER = P0 = E 0
EPS0
PAT0
EPS1
PAT1
As PAT1=PAT0(1+g), the relationship between PER and PER* is: PER* = PER (1+g)
We use the asterisk (*) to identify the ROE* calculated by dividing this years profit by the equitys
book value this year.
Performing similar operations, we obtain: ROE* = PAT0 / Ebv0 = ROE / (1+g)
In 8, we show that PER* is split as follows:
1
ROE * - Ke
PER *
+ FF * x G
FF* =
+ 1
Ke
ROE * Ke

G=

g
Ke - g

In 8, we also show that the difference between FF and FF* is:


g
g
FF * -FF = 1 = 1 ROE
ROE * (1+ g)
Table A2 shows PER* and FF* for all six companies in the previous example.
Table A2. PER* and FF* of six companies.
A
B
C
D
9.434
10
12
11.111
3.774
10
12
3.704
10.60
10.00
10.00
18.00
9.43%
10.00%
12.00%
11.11%
1.5
0
0
4
0.4
1
2.667
2
0.6
0
0
8.000

PATo
DIVo = ECFo
PER*
ROE*
G
FF*
G x FF*

E
11.321
5.660
13.25
11.32%
1.5
2.167
3.250

F
12.150
5.607
16.46
12.15%
2.333
2.769
6.462

3. PER, Interest Factor and Risk Factor


We have already said that (1/Ke) is the PER the company would have if it did not grow. This term can
be split into two terms:

1
Ke

1
Ke - RF
Ke RF
RF

The first term (1/RF) is the PER the company would have if it did not grow and had no risk. It is approximately- the PER of a long-term Treasury bond. This term is called Interest Factor. The second term
depends primarily on the difference between the required return to equity (Ke) and the risk-free interest rate
(RF). The value of this term increases as the required return to equity increases (which depends on the risk
perceived by the market). This is why it is called Risk Factor.
Interest Factor =

1
RF

Risk Factor =

PER

Ke - RF
1
1

Ke RF
RF Ke

1
Ke - RF
+ FF x G
RF
Ke RF

PER = Interest Factor - Risk Factor + Franchise Factor x Growth Factor


Likewise:

PER *

1
Ke - RF
+ FF * x G
RF
Ke RF

PER* = Interest Factor - Risk Factor + Franchise Factor* x Growth Factor

CH27- 12

Pablo Fernandez
IESE Business School, University of Navarra

Ch27 PER, P to Book and growth

Franchise
Factor

FF

PER
due to
growth

(ROE-Ke)/(ROE Ke)
Growth
Factor

FF x G

G
PER

g/(Ke-g)

P / EPS

Risk
Factor
PER
without
growth

(1/RF)-(1/Ke)
Interest
Factor

1/Ke

1/R F

4. Value generation over time in companies with growth


Figure A1 shows the evolution over time of the profits and dividends of companies A (annual
growth = 6%) and B (without growth). Both companies have the same equity value (100 million). The expected
dividends of company B are 10 million every year. The expected dividends of company A are 4 million in year
1, growing thereafter at an annual rate of 6% in the following years. The dividends of company A will not reach
10 million (the dividends of company B) until 16 years from now.
Figure A1. Evolution of the profits and dividends of companies A and B.
PAT A

20

DIV A

PAT B = DIV B

15
10
5
0
0

10

15
year

20

25

30

Figure A2. Evolution of the profits and dividends of companies A and C.


PAT A

20

DIV A

PAT C = DIV C

15
10
5
0
0

10

15
year

20

25

30

Figure A2 shows the evolution over time of the profits and dividends of companies A (annual
growth = 6%) and C (without growth). The equity value of company A is 100 million and the equity value of

CH27- 13

Pablo Fernandez
IESE Business School, University of Navarra

Ch27 PER, P to Book and growth

company C is 120 million. The expected dividends of company C are 12 million every year. The dividends of
company A will not reach 12 million (the dividends of company C) until 19 years from now.
Figure A3 shows the evolution over time of the profits and dividends of companies D (annual growth
= 8%) and F (annual growth = 7%). Both companies have the same equity value (200 million). The expected
dividends of company D are 4 million in year 1, growing thereafter at an annual rate of 8%. The expected
dividends of company F are 6 million in year 1, growing thereafter at an annual rate of 7%. Although it seems
in Figure A3 that the dividends of company D are always less than those of company F, they will in fact catch
up with the dividends of company F in 45 years time!!!!
Figure A3. Evolution of the profits and dividends of companies D and F.
PAT D
DIV D
PAT F
DIV F

40
30
20
10
0
0

10

15
year

20

25

30

Figure A4 and Table A3 show the equity value generation over time: the present value of the dividends
until a certain year. Thus, the present value of the dividends for the first 20 years is 52 million for company A,
85 million for company B, 61 million for company D, and 85 million for company F. The present value of
companies B and F match in year 20 and that of companies B and D in year 36.
Figure A4. Equity value generation over time. Present value of the dividends until the year indicated.
Company A
Company B
Company D
Company F

200
175
150
125
PV 100
75
50
25
0
0

20

40

year

60

80

100

Table A3. Equity value generation over time. Present value of the dividends until the year indicated.
Year Company A Company B Company C Company D Company E Company F
17
38
45
18
25
26
5
31
61
74
34
46
48
10
43
76
91
48
64
68
15
52
85
102
61
78
85
20
67
94
113
85
101
113
30
77
98
117
104
116
134
40
84
99
119
120
126
150
50
94
100
120
149
141
175
75
98
100
120
168
146
187
100
99
100
120
180
149
194
125
100
100
120
187
149
197
150
100
100
120
192
150
198
175
100
100
120
195
150
199
200

CH27- 14

Pablo Fernandez
IESE Business School, University of Navarra

Ch27 PER, P to Book and growth

Figure A5 shows the equity value generation over time: the present value of the dividends until a
certain year as a percentage of the equitys value today. Thus, the present value of the first 20 years dividends
is 52% of its value (100 million) for company A, 85% of its value (100 million) for company B, 31% of its
value (200 million) for company D, and 42% of its value (200 million) for company F.
Figure A5. Equity value generation over time.
Present value of the dividends until the year indicated as a percentage of the equity value.
100%
80%
60%
Company A
Company B
Company D
Company F

40%
20%
0%
0

20

40

year

60

80

100

5. Influence of growth on the franchise factor and on the Growth Factor


Figure A6 shows the relationship between the franchise factor multiplied by the Growth Factor and
the growth rate for four companies with different ROEs. Note that in the company with ROE = 9%, that is, less
than the required return to equity, which is 10%, the higher the growth rate, the lower the product FFxG, which
becomes negative. In the case of the company with ROE = 10% (equal to the required return to equity), the
product FFxG is always 0. For companies with a ROE greater than the required return to equity, the higher the
growth rate, the higher the product FFxG.
Figure A6. FF x G of a company with different growth rates (g). Ke = 10%
ROE = 9%
ROE = 10%
ROE = 11%
ROE = 12%

15
10
5
FF x G
0
-5
-10
0%

1%

2%

3%

4%
5%
g (growth)

6%

7%

8%

9%

6. Influence of the ROE on the franchise factor


Figure A7. FF of a company with different values for ROE. Ke = 10%
6
4
2
0
FF -2
-4
-6
-8
-10
5%

6%

7%

8%

9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
ROE

Figure A7 shows the franchise factor at different ROEs. Companies with different growth rates have
an identical franchise factor, as the franchise factor does not depend on growth. Figure A7 also shows that if
the ROE is equal to the required return to equity, i.e. 10%, the franchise factor is 0. For companies with a ROE

CH27- 15

Pablo Fernandez
IESE Business School, University of Navarra

Ch27 PER, P to Book and growth

less than 10%, the franchise factor is negative and, for companies with a ROE greater than 10%, the franchise
factor is positive.
Figure A8 shows the product of the franchise factor by the Growth Factor at different ROEs, for
companies with different growth rates. Again it is showed that for a ROE of 10%, the franchise factor
multiplied by the Growth Factor is 0, irrespective of the companys growth rate. Companies with high growth
have a product FFxG greater than 0 if the ROE is greater than 10%, and less than 0 if the ROE is less than 10%.
Figure A8. FF x G of a company with different values for ROE. Ke = 10%
g=0
g = 2%
g = 5%
g = 8%

15
10
5
FF x G
0
-5
-10
3%

4%

5%

6%

7%

8%

9% 10%
ROE

11%

12%

13%

14%

15%

7. Influence of the required return to equity on the Franchise Factor and on the PER
Figure A9 shows the relationship between the franchise factor multiplied by the Growth Factor and
the required return to equity. As was to be expected, when the required return to equity increases, the product
FFxG decreases. In the case of companies whose ROE is greater than the required return to equity, the product
FFxG increases rapidly when the required return to equity decreases.
Figure A9. FF x G of a company with different values for Ke. ROE = 10%
g=0
g = 2%
g = 5%
g = 8%

10

5
FF x G
0

-5
5%

6%

7%

8%

9%

10%
Ke

11%

12%

13%

14%

15%

Figure A10 FF x G of a company with different values for Ke. g=4%


ROE = 9%
ROE = 10%
ROE = 11%
ROE = 12%

8
6
4
FF x G
2
0
-2
6%

7%

8%

9%

10%

Ke

11%

12%

13%

14%

15%

Figure A10 shows the relationship between the franchise factor multiplied by the Growth Factor and
Ke but this time we can see how this relationship changes when the ROE changes: the higher a companys
ROE, the higher the product FFxG.

CH27- 16

Pablo Fernandez
IESE Business School, University of Navarra

Ch27 PER, P to Book and growth

Figure A11 shows how the franchise factor changes depending on the required return to equity. As is
logical, the franchise factor decreases as the required return to equity increases.
Figure A11. FF of a company with different values for Ke. g=4%
8

ROE = 9%
ROE = 10%
ROE = 11%
ROE = 12%

6
4
FF 2
0
-2
-4
6%

7%

8%

9%

10%

Ke

11%

12%

13%

14%

15%

Figure A12 shows the evolution of the Spanish stock markets franchise factor and the its average
PER. The franchise factor increased from 1994 to 1998, but was negative in 1992.
Figure A12. FF and PER of the US stock market.
8

PER 34

Franchise factor

30

26

22

18
FF USA
PER USA

-2
-4
12/90

12/91

12/92

12/93

12/94

12/95

8. Splitting the PER. Proof.


It is easy to show that for a growing perpetuity, PER =

12/96

12/97

12/98

12/99

ROE - g
p

Ke g ROE (Ke g)

12/00

14
10
12/01

(1)

In a company with constant growth and performing algebraic operations, it is readily deduced that7:
E0
ROE - g
=
Ke g
Ebv 0
Substituting this expression into the previous one, we obtain:

PER =

ROE - g
1
p
E0

Ke g ROE(Ke g) ROE Ebv0

As g = ROE (1-p), substituting and performing algebraic operations, we obtain:

1 Ke (ROE - g)
1
Ke (ROE - g) - ROE (Ke - g)
Ke p
=

1 +
=

Ke
ROE (Ke - g)
Ke - g Ke ROE (Ke - g)

(ROE - Ke) g
1
1
+

+ FF x G
=
ROE Ke (Ke - g) Ke
Ke

PER =

p
1

Ke - g Ke

7
Comparing ROE (which is an accounting number) with Ke (which is the required return) is always dangerous.
As a general rule, it is not true (except for perpetuities, which is the case we are considering here) that the
condition for a company to create value is that ROE be greater than Ke.

CH27- 17

Pablo Fernandez
IESE Business School, University of Navarra

PER

1
+ FF x G
Ke

Ch27 PER, P to Book and growth

Where: FF = ROE - Ke
ROE Ke

g
Ke - g

G=

Performing algebraic operations, the first addend can be expressed as:

1
Ke

1
Ke - RF
Ke RF
RF

We call the first term Interest Factor and the second term Risk Factor:
Interest Factor =

1
RF

Risk Factor =

Ke - RF
Ke RF

1
Ke - RF
+ FF x G
RF
Ke RF

PER

PER

1
Ke - RF ROE - Ke
g
+
x
RF
ROE Ke
Ke - g
Ke RF
PER = Interest Factor - Risk Factor + Franchise Factor x Growth Factor

P0
E0
=
EPS0
PAT0
As PAT1=PAT0(1+g), the relationship between PER and PER* is:

If PER * =

ROE* = PAT0 / Ebv0 = ROE / (1+g)

PER* = PER (1+g)

g = ROE (1-p) = ROE* (1-p) (1+g)

ROE * (1 + g) - g
ROE * (1 + g)
p (1 + g) 1 Ke p (1 + g)
1 Ke [ROE * (1 + g) - g]
PER * =
=

Ke - g
Ke
Ke - g
Ke
ROE * (Ke - g)

p=

1 Ke [ROE * (1 + g) - g] - ROE * (Ke - g)


1+
Ke
ROE * (Ke - g)
FF* =

PER *

1 (ROE * - Ke + Ke ROE*) g
1

+ FF * x G
= Ke +
ROE * Ke (Ke - g)
Ke

ROE * - Ke
+ 1
ROE * Ke

1
+ FF * x G
Ke

g
Ke - g

G=

PER *

1 Ke - RF
+ FF * x G
RF Ke RF

FF* - FF = 1 g/ROE = 1 g/[ROE* (1+g)]


REFERENCES
Leibowitz, M. L., and S. Kogelman (1992), Franchise Value and the Growth Process, Financial Analysts
Journal 48, pages 53-62.

Questions
How do you interpret figures 13 and 14?
What did happen to Sealed Air Corp. for having negative book value of equity during 5 years?
Please define:
Price to Earnings ratio

Value to Book ratio

Growth

Leveraged recapitalization

Please define and differentiate:


ROE (Return on Equity). Shareholder return
Franchise factor, growth factor, interest factor and risk factor
Equity book value. Market capitalization

CH27- 18