by MartinL.

Leibowitz and Stanley Kogelman

Inside the P/E Ratio: The Franchise

Factor
Thisarticlelooks"inside"the DDM-basedprice/earnings ratioand providesa surprisingly
simplemodelof thefuture investmentopportunitiesrequiredto supportan above-market
PIE. Theanalysisis doneunderthe idealizedassumptionsof certainreturns,no taxesand
no leverage.Further,all stocksare takento be pricedaccordingto the dividenddiscount
model.Undertheseconditions,the ingredientsof PIEexpansioncan be separatedinto two
factors-(1) a FranchiseFactorthat representsthe PIE impactof new investmentsat a
specifiedreturn and (2) a growth measurethat reflectsthe magnitudeof these new
investmentopportunities.
The FranchiseFactor depends on the return availableon new investments. For
at-market-ratereturns,theFranchiseFactoris zero.Consequently, investmentsthatprovide
such returnsdo not add to the PIE. Only investmentsthat provideabove-market returns
leadto a positiveFranchiseFactorand an above-market PIE. Twosurprisingresultsof the
analysis are the small size of the FranchiseFactorand the extraordinarymagnitudeof
growth requiredto raise PIE significantly.For example,a firm with an ROE 300 basis
pointsabovethe marketrate must havefranchiseinvestmentopportunitiesequivalent,in
present-valueterms,to five timesits currentbookvalueto supporta PIE that is twice the
marketrate.
Thedecomposition of the PIEsuggestedin this articleallowsthe analystto cut through
the confusionthat can arise from the standardDDM formulation,which intertwines
assumptionsregardinga constant-growthprocess,implicitreturn levels and dividend-
payout policies. As a result, the FranchiseFactor approachcan provide a sharper
understandingof the real ingredientsthat lead to higherequity values and betterPIE
multiples.

E QUITYANALYSTSuse a combinationof J. B. Williams and then modified and extended

judgment, understanding of an industry,
detailed knowledge of individual compa-
nies, and an arsenal of analytical models and
measures to help them assess value. The mea-
sures include cash flow, returnon equity (ROE),
dividend yield, and financial ratios such as
price/earnings, price/book, earnings per share
and sales per share. Among the ratios, the
price/earnings ratio (P/E) stands out as one of
the most scrutinized, modeled and studied mea-
sures in use today.
The classical model used to estimate a theo-
retical P/E ratio is the dividend discount model
(DDM). This model was originally proposed by
by M. Gordon, M. H. Miller and F. Modigliani,
and others.1 DDM-based models can yield sig-
nificant insights into how various factors influ-
ence P/E.
We have found that investors generally fail to
appreciate the magnitude and type of growth
required to support a high P/E multiple. The
problem stems in large part from our tendency
to view growth in an overly simplisticmanner-
i.e., as a smooth pattern of constant growth,
self-funded by retained earnings, generating
added earnings with each growth increment.
1. Footnotes appear at end of article.

FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER 1990 017

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Glossary
Base P/E:The P/E of a firm with constant earnings
over time. The P/E of such a firm is simply the
inverse of the marketdiscount rate.
Franchise Factor: The P/E increase that results
from one unit of present-value Growth Equiva-
lent investment. In other words, if the present
value of new investments were equivalentto the
current size of the firm, then the P/E multiple
would increaseby an amount equal to the Fran-
chise Factor.
Full-Payout Equivalent: All firms that provide
only the base P/E are called full-payoutequiva-
lents. From the investor's point of view, a firm
that retains part of its earnings but has no
above-market investment opportunities offers
no advantage in comparison with a firm that
pays out all its earnings as dividends.
Growth Equivalent: The present-value Growth
Equivalentinvestment is the sum of the present
values of all future investment opportunities
expressed as a percentage of the original book
value of a firm.
Growth Rate: The constant annual rate at which
both earnings and dividends grow.
Side Pool of Wealth: The cumulative portfolio
value gained by an equity investor who contin-
ually reinvests all dividends (and interest)at the
market rate.
This is a convenient and appealing concept. It
forms the basis for most standard forms of the
DDM, which are built on the assumption that
dividends, earnings and/or book values grow at
the same constant rate. Typically, growth is
assumed either to continue at the same rate
forever or to be composed of two or three
different growth rates covering various consec-
utive time periods. Most DDMs furtherassume
that growth in dividends is solely the result of
retained earnings. Beyond its role in DDM mod-
els, the smooth-growth concept has had an even
greater impact as the basis for many of our
intuitions regarding the value of equity.
Despite its appeal, this simple concept of
growth can be misleading on several counts.
First, not all growth produces incremental
value. Consider, as a simple illustration, the
"growth" in the amortized value of a discount
bond. This growth does not add to the bond's
promised yield to maturity; it is simply one
means of deliveringon that original promise.
Similarly, for equities, growth alone is not
enough. The routine investments that a firm
FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER 1990 0 18
makes at the market rate do not add net value,
even though they may contribute to nominal
earnings growth. (Investments at below-market
returnsactuallysubtractfrom value.) Incremen-
tal value is generated only through investment
in exceptionalopportunities that promise above-
market ROEs. Only this exceptional "high-
octane" growth fuels the engine for higher P/E
multiples.
Another point of confusion inherent in our
usual assumptions about growth is the notion
that growth should be self-funded out of re-
tained earnings. This concept is also appealing:
A smoothly growing flow of new investments
would appear to be the just reward for a thrifty
corporation and its investors. The key issue,
however, is not whether the company has re-
tained sufficient earnings to self-fund a new
investment opportunity, but rather whether
that opportunity offers an above-marketreturn.
Such exceptional opportunities, by definition,
only come in fits and starts. They tend to result
from some monopolistic event that may or may
not be sustainable.
When a corporationis presented with such an
exceptional"franchise"opportunity, the invest-
ment should be pursued regardless of whether
the funds are available within the corporate
coffers.2In today's financialmarkets, the ability
to self-fund should not be a constraint.Theoret-
ically, the market should always be willing,
through the purchase of new securities, to sup-
ply funds to facilitateparticipationin an above-
market return. The pursuit of exceptional re-
turns should be limited only by the infrequency
of their occurrence.
This articlelooks "inside" the DDM-basedP/E
and beyond the restrictions of smooth growth
through retained earnings. The result is a sur-
prisingly simple model of the exceptionalfuture
investment opportunities implicit in any given
P/E. By representing all future investments by
their present values, we can capture the impact
of embedded opportunities on the P/E in a
single number, which we call the "Franchise
Factor."
A Brief Description
Our focus is narrow. We consider only a no-tax
world, and we always assume a stable marketin
which all stocks are unleveraged and priced
according to the DDM. We do not account for
the uncertainty and volatility endemic to the
equity markets. We also assume that all earn-
ings are properly reported and that each firm's
ROE remains unchanged over time.
In fact, our discussion of P/E treats equity
investments as if their earnings, growth and
dividends were all certain. We thus tackle the
complex and uncertain cash flows associated
with equities in much the same manner as one
analyzes the price/yield characteristicsof risk-
free bonds.
To explore the interactions between P/E,
ROE, growth and the Franchise Factor, we
consider the cash flows and reinvestment in-
come of four illustrativefirms (A, B, C and D).
Firm A's ROE precisely equals the market capi-
talization rate. The firm retains two-thirds of its
earnings and reinvests them at the marketrate.
By contrast, Firm B has the same ROE as Firm
A, but it maintains a 100 per cent dividend-
payout policy. We show that FirmA's growth is
deceptive in that it does not add to currentvalue
or to P/E. In fact, according to the DDM, Firms
A and B have exactly the same stock price and
the same P/E.
Firm C has a higher ROE than Firm B based
on its historical book value, but like Firm B, it
maintains a 100 per cent dividend-payout pol-
icy. Despite its high ROE and premium price,
Firm C has no growth. We might think of this
firm as offeringa very specialized service within
a limited but saturated market: There is no
opportunity for business expansion, but the
firm's products command a premium price.
Although the return on initial investment may
be quite high, the market value of the firm is
such that it only offers the same P/E as FirmsA
and B. Neither growth alone nor above-market
ROEalone is sufficient to command a premium
P/E.
Firm D illustrates the importance of combin-
ing growth and above-market returns on the
new investments comprising that growth. This
firm has an ROE 300 basis points above the
market rate and a P/E twice that of the other
three firms. The DDM leads to the rather sur-
prising implication that Firm D requires excep-
tional investment opportunitiesthat, in present- accordingto the standard DDM.
value terms, amount to a 500 per cent "jump"in
the firm's currentbook value.
P/E Ingredients
The resultsfor these fourfirmscan be explained nents-dividend return, price return and rein-
in terms of the FranchiseFactorconcept. For a vestment return.4Because, by assumption, the
specified return on new investments, the Fran- firm's earnings grow at 8 per cent and dividend
chise Factoris the P/E increase that results from policy remains unchanged, dividends will also
one unit of present-value "growth." In other
words, if we were to make new investments in
magnitude equivalent to the current size of the
firm, then the PIE multiple would rise by an
amount equal to the FranchiseFactor.
The Franchise Factor depends on the return
available on new investments. For at-market-
rate returns, the Franchise Factor is zero. At
higher-than-marketreturns, the FF increases-
quickly at first, but ultimately approaching a
maximum level. At the return level for Firm D,
the FranchiseFactoris 1.67-a reasonably high
value. By combining Firm D's five units of
"growth" (500 per cent of original book value)
with its FranchiseFactorof 1.67, we arrive at a
new and more penetrating view of why its P/E
ratio is twice the P/E of the other three firms.
We can separatethe ingredients of P/Eexpan-
sion into two factors-(1) a FranchiseFactorthat
represents the P/E impact of new investments at
a specified returnand (2) a growth measure that
reflects the magnitude of these new investment
opportunities.3 This simple decomposition al-
lows the analyst to cut through the confusion
that arises because of the way the DDM inter-
twines assumptions regarding a constant-
growth process, implicit return levels and divi-
dend-payout policies. As a result, we believe
that the FranchiseFactorapproach can provide
a sharper picture of the real components of
enhanced equity value and P/E multiple.
Stable Growth in Earnings and
Dividends
Firm A maintains a constant dividend-payout
policy (i.e., the dividend-payout ratio is main-
tained at 33-1/3per cent of earnings) and expects
earnings to grow at a steady 8 per cent per year
far into the future (see Table I). The market
capitalizationrate is constant at 12 per cent; the
firm's ROE is also 12 per cent. The initial book
equity is $100, so a 12 per cent ROE leads to
earnings of $12, dividends of $4 and retained
earnings of $8. The price of the stock is $100,
What are the cash flows to an investor in Firm
A, under the simplifying assumptions that the
investment is subject to neither risk nor taxes?
The investor's return will have three compo-

FINANCIALANALYSTSJOURNAL/ NOVEMBER-DECEMBER
1990O 19
Table I FirmA, with a Constant 8 Per Cent Growth Rate
and a 12 Per Cent ROE
Book Equity $100.00
ROE 12.00%
Earnings $12.00
Payout Ratio 331/3%
Dividend $4.00
MarketRate 12.00%
Price $100.00
Dividend Yield 4.00%
Growth Rate 8.00%
P/E Ratio 8.33
grow at the same 8 per cent rate. Figure A
illustrates this.
Price appreciation is a consequence of our
assumptions regarding the firm and our use of
the DDM for pricing the stock. In particular,the
DDM implies that, in a static market, price
growth will keep pace with dividend growth.
Thus, if dividends grow at 8 per cent, stock
price will also grow at 8 per cent.
A new investor who buys FirmA's stock will
realize a 4 per cent return from dividends and
an 8 per cent return from price appreciation.In
total, over the course of one year, the investor
will experience a return on the stock purchase
price that is equal to the market rate of 12 per
cent. In Figure B, the year-to-year dollar price
appreciation is added to the dividend flow at
each point in time. Observe that, in dollar
terms, the combination of price appreciation
and dividends increases dramatically.
In the absence of risk, the stock of Firm A is
equivalent to a perpetual bond that has a con-
stant 4 per cent coupon based on a principal
balance that appreciatesat 8 per cent per year. If
the perpetual's principal is initially $100, the
first coupon payment is $4. This $4 payment is
the same as the first dividend for Firm A.
At the end of the first year, the perpetual's
principalis assumed to increase by 8 per cent to
$108. As a result, the second coupon will be
$4.32 (4 per cent of $108). This agrees with the
second dividend payment of Firm A, because
the dividend grows at 8 per cent. Over time, the
perpetualbond provides coupon payments that
are the same as the dividends for Firm A.
Figure B provides an incomplete picture of
growth in asset value for a long-term, tax-free
investor, because it does not account for the
third component of investor return-the gains
from reinvesting all dividends. We assume that
the investor has the opportunity to continue to
invest in the equity market and earn the 12 per
cent market rate.5 Thus, if all dividend pay-
ments are invested, and those investments com-
pound at a 12 per cent rate, the investor will
build a growing "side pool" of wealth. This pool
will consist of all accumulated dividends, "in-
terest" on those dividends, and the further
compounding of this additional "interest on
interest" (or, more accurately, "dividends on
dividends").
Figure C adds the incremental year-by-year
return from this compound interest on interest
to the combination of price appreciation and
dividends. It thus gives us the full picture of the
growth in portfoliovalue for an investor in Firm
A. At first glance, the overall pattern of total
investment return seems to correspond to what
would be characterizedas a "growth" invest-
ment. In the early years, price growth is the
dominant component of return. Over time,
however, interest on interest begins to domi-
nate. The increasing importance of interest on

Figure A Dividend Growth Over Time for Firm A*

$100 _

80 -

Z 60
40

20

0 I
0 5 10 15 20
Year
*ROE 12%;payoutratio = V3;growth rate = 8%.

FINANCIALANALYSTSJOURNAL/ NOVEMBER-DECEMBER
1990[ 20
 Figure B Growthin Dividends and PriceOver Time for FirmA*

$100 0 PriceChange

80 i * Dividend

60 -
40
40

20 -
a~~~~~~~~~Ya

*ROE= 12%;growth rate = 85. 1

interest is consistent with the return patterns of
fixed-income securities.
Stable Growth vs. Zero Growth
Firm B appears, at least on the surface, to be
quite different from Firm A. As Table II indi-
cates, Firm B has the same earnings as Firm A,
but it has a 100 per cent payout ratio;that is, all
earnings are paid out as dividends on a year-by-
year basis. Thus Firm B is just the opposite of a
growth stock; it has no growth in earnings,
dividends or price.
Figure D illustratesthe (ratherdull) stream of
direct payments from FirmB. Dividends remain
constant and, in the absence of a change in the
discount rate, there is no priceappreciation.The
payment stream for Firm B is identical to the
payment stream for a perpetual bond with a 12
per cent coupon and a principalof $100.
Figure E compares the period-by-perioddivi-
dends of FirmsA and B. The dividend streamof
Firm B clearly dominates in the early years. By
year 15, however, Firm A's earnings have
grown enough that its dividends surpass those
of Firm B.
Figure F illustrates the total of price appreci-
ation and dividends for Firm B and for Firm A.
For Firm B, the price never changes; the firm's
100 per cent dividend-payout policy means no
growth. For Firm A, the first year's 4 per cent
dividend yield plus 8 per cent price gain
matches the 12 per cent dividend payment of
Firm B. As time passes, however, both the
dividend and the price gain from Firm A grow
in dollar terms. The combined gain pulls in-
creasingly ahead of the fixed $12 payment from
Firm B.
Direct vs. Indirect Investment
The comparisonin Figure F seems to suggest
that the growth propertiesof FirmA enable it to
outrun the stable 12 per cent returnfromFirmB.
Firm B does have one advantage over Firm A,
however. Because Firm B pays out all earnings
as dividends, an investor in this firm has the
option either to spend or to reinvest his divi-

Figure C Growth in Portfolio Value for an Investor in Firm A*

$100
$ PriceChange
80
~Dividend
6 E l ntereston Interest
aLAS
-
04 40 11z N

20
20
0 5 10 15 20
Year

*ROE = 12%; growth rate = 8%

FINANCIALANALYSTSJOURNAL/ NOVEMBER-DECEMBER
1990O 21
Table II FirmB, with No Growth
Book Equity
ROE
Earnings
Payout Ratio
Dividend
MarketRate
Price
Dividend Yield
Growth Rate
P/E Ratio
dend proceeds. By contrast, Firm A's price
appreciationcannot be "spent" by the investor.
By retainingearnings and adding to book value,
Firm A in essence takes charge of a major
component of the reinvestment process.
According to the assumptions of the DDM,
66-2/3per cent of FirmA's earnings are retained
(100 per cent less than 33-1/3 per cent payout).
These retained earnings are reinvested to pro-
duce additional income at the same rate as the
firm's initial ROE. For Firm A, this implies that
retained earnings earn the 12 per cent market
rate, because that was the initial ROE.
The same investment opportunity is directly
availableto an investor in FirmB. This investor
can invest all dividend receipts into the general
equity market and earn the 12 per cent rate. All
the earnings of both firms will thus be put to
work at 12 per cent, either by Firm A's invest-
ment of retained earnings or by Firm B's inves-
tors' reinvestment of dividends received.
On the basis of returns alone, an investor
should be indifferentbetween FirmA and Firm
B. As FigureG illustrates,when the incremental
year-by-yearreturn from interest on interest is
layered on top of dividends and price gains,
Figure D Dividends Over Time for Firm B*
$100
80 -
: 60 -
a _
40
20
00 nnnnnnnnnnnnnnnnnn
5 10 15
'ROE = 12%; payout ratio = 1; growth rate = 0%.
FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER 1990 [
Firm B offers precisely the same year-by-year
increments in portfolio value as Firm A. Thus,
$100.00
12.00%
under stable marketconditions, both firms pro-
$12.00 duce compound returns equal to the 12 per cent
100.00% market rate.
$12.00
It should be noted that the stocks of the two
12.00% firms will exhibit different sensitivities to
$100.00
12.00% changes in market assumptions. Because the
0.00% growth stock of FirmA "compounds internally"
8.33 at 12 per cent, it may have a longer duration,
hence a greater sensitivity to declining market
discount rates, than the stock of Firm B.6 The
stocks are thus not identical under dynamic
marketconditions. Our focus, however, is total
portfolio returns under stableconditions.
In summary, from the point of view of the
fully compounding, tax-free investor, Firms A
and B are equivalent in terms of total return.
They are also equivalent in terms of price,
because the dividend streams from both firms
have the same present value of $100. Moreover,
because the earnings are the same, both stocks
have the same P/E ratio-8.33. Figure H high-
lights the differences between the dividend
yields, payout ratios and growth rates of the
two firms and the similarity in the firms' P/E
ratios.
Internal Growth vs. External Growth
To gain more insight into the P/E ratios of the
two firms, we now turn to an analysis of their
earnings streams. Both firms start with a book
value of $100 and first-yearearnings of $12 (12
per cent of $100). FirmB continuallypays out all
its earnings as dividends, and its book value
remains constant at $100. In contrast, Firm A
retains 66-2/3 per cent of each year's earnings
and adds this amount to its book value.
_
20
Year
22
Figure E The Dividend Streams of Firm A and Firm B

$100 Dividend of FirmB (no growth)

80 * Dividendof FirmA (8%growth)

E 60 -

X 40 _

20 _
OI iiiu
0 5 10 15 20
Year

In the first year, FirmA retains $8 (two-thirds
of 12 per cent of $100), thereby bringingits book
value up to $108 (1.08 x $100)by the end of that
year. As book value increases, total dollar earn-
ings rise, because the same 12 per cent ROE
applies to an ever-largerbase. The firm's earn-
ings will be $12.96 in year 2 (that is, the ROEof
12 per cent applied to a book value of $108),
$14.00 in year 3, and so on. Firm A thus has a
pattern of continual earnings growth similar to
the return pattern illustratedin Figure B.
We can now comparethe year-by-yearP/Esof
the two firms. At the outset, both stocks are
priced at $100 and have earnings of $12. Hence
both stocks have identical P/Es of 8.33. For Firm
B, however, neither price nor earnings ever
grow beyond their initial value, because all
earnings are paid out as dividends. Hence the
P/E for Firm B always remains at 8.33. We refer
to this figure as the "base P/E."
Some insight into this base P/E of 8.33 can be
gained by comparing Firm B's stock with a
perpetual bond with a 12 per cent coupon. The
price of such a bond is found by dividing the
earnings (thatis, the coupon payment of $12)by
the yield (that is, the 12 per cent market rate).
This is equivalent to the requirement that the
P/E ratio be the same as the reciprocal of the
yield. Thus our P/E ratio of 8.33 is the same as
1/0.12.
For Firm A, we just observed that dollar
earnings build year by year in direct proportion
to the 8 per cent growth in book value. Under
the assumed stable marketconditions, the price
of FirmA's stock also appreciatesby 8 per cent
per year, in accordance with the growth in
dividends and earnings. The price will be
$100.00 in year 1, $108.00 in year 2, $116.64 in
year 3 and so on. Accordingly,in year 2, the P/E
for Firm A will equal:
P/E = ($100 x 1.08)/($12x 1.08)
= $100/$12 = 8.33.
In year 3, the P/E will be:
P/E = ($100 x 1.082)/($12x 1.082)

Figure F Total of Dividends and Price Appreciation for Firm A and Firm B

$100 V PriceChange

80 DDividendof FirmB (no growth)

60 * Dividendof FirmA (8%growth)
A
40 _

20 -

0 5 10 15 20
Year

1990O 23
FINANCIALANALYSTSJOURNAL/ NOVEMBER-DECEMBER
FigureG TotalAnnual Growthin PortfolioValuefor an Investorin FirmB vs. Investorin FirmA*

$100 Intereston Interest

80 _ g PriceChange

= 60 :3 Dividendof FirmB (no growth)

*Dividend of FirmA Ari .
40 (8%growth)

20

0 5 10 15 20
Year

*Assumingequal initial investment.

= $100/$12 = 8.33. pend,on their respective firms' earnings, they

In other words, the P/Efor FirmA remains at its
initial value of 8.33. Thus FirmA has exactly the
same P/E as Firm B, in every period.
One might have intuitively expected a higher
P/E ratio for Firm A because it appears to be a
growth firm. As we saw earlier, however, any
firm that reinvests only at the marketrate is not
providing any special service to its investors;
they could themselves reinvest dividend re-
ceipts at this same rate. Reinvestment at the
marketrate is thus tantamountto paying out all
earnings to the investors: The reinvestment
rates are the same; only the labels are different.
Firm A, although a growing enterprise, is
fundamentally generating the same value for
the investor as the full-payout Firm B. All full-
payout firms and full-payout equivalents, such
as Firm A, have the same price as a perpetual
bond with an annual coupon payment equal to
its (current) earnings. Moreover, while the
prices of full-payout-equivalentstocks will de-
will all have the same base P/E ratio of 8.33.
In particular, under our scenario, any firm
with a 12 per cent ROEis equivalentin P/Evalue
to Firm B, regardless of the firm's dividend
payout policy. Furthermore,as we shall demon-
strate below, any full-payout firm is also equiv-
alent in P/E value to Firm B, regardless of its
ROE.
A key conclusion emerging from this compar-
ison of Firms A and B is that investors will not
"pay up" in price or in P/E ratio for a firm that
reinvests at just the market rate. A firm must
achieve a return in excessof the market rate on
newinvestments to command a P/E in excess of
the base P/E.
Above-Market ROEs
FirmC has a 15 per cent ROEbut, like FirmB, a
100 per cent dividend-payout policy. It thus has
no expectation of future growth (see Table III).
Based on an initialbook value of $100, FirmC
earns $15 annually in perpetuity. Consequently,

Figure H A Comparison of the Characteristics of Firms A and B

100%
B

1 2Y
0
I
8.33% 8.33%
A 331/3%10/(C 8%11/c
4%

Dividend Payout Growth P/E

Yield Ratio Rate Ratio

FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER 1990 C 24

the price of its stock must be at a premium to
book (that is, the stock is priced at $125)to bring
its return down to the marketrate of 12 per cent
(- [15/125] x 100%).7Because all earnings are
paid out as dividends, the dividend yield for
this firm is also 12 per cent.
As in the case of Firm B, Firm C's stock is
equivalent to a perpetual bond. The difference
between the two perpetuals is that Firm C's
stock is equivalent to a sort of premium bond
with a 15 per cent coupon, while FirmB's stock
is equivalent to a par bond with a 12 per cent
coupon. From an investor's viewpoint, Firm C
offers no advantage over Firm B. Both firms
provide the same dividend yield and no price
appreciation.The only differencebetween them
is their stock price. The fundamental similarity
between Firms B and C is reflected in their P/E
ratios:Firm C has the same 8.33 ($125/$15)base
P/E as Firm B. Thus Firms A, B and C are all
full-payout-equivalentfirms.
A Reinvesting Firm with an Above-
Market ROE
Firm D is significantly different from the full-
payout-equivalentFirmsA, B and C. FirmD has
the same 15 per cent ROEas FirmC, but a 33-1/3
per cent payout ratio. It differs from all the
preceding firms in that it can apply its above-
market ROE of 15 per cent to any new invest-
ment based on retained earnings.
As a result of its above-market investment
opportunities and 10 per cent growth rate, Firm
D will be worth more than the $125price of Firm
C. In fact, Firm D's initial price is $250 (see the
next section and the appendix for details). Table
IV gives the basic characteristicsof Firm D.
Our investigation of Firm D begins with an
analysis of the three components of return for
fully compounding, tax-free investors. Because
the initial stock price is no longer $100, a com-
Table III FirmC, with a 15 Per Cent ROEand No Growth
Book Equity $100.00
ROE 15.00%
Earnings $15.00
Payout Ratio 100.00%
Dividend $15.00
MarketRate 12.00%
Price $125.00
Dividend Yield 12.00%
Growth Rate 0.00%
P/E Ratio 8.33
FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER 1990 O 25
Table IV Firm D, with a Constant 10 Per Cent Growth
Rate
Book Equity $100.00
ROE 15.00%
Earnings $15.00
Payout Ratio 331/3%
Dividend $5.00
MarketRate 12.00%
Price $250.00
Dividend Yield 2.00%
Growth Rate 10.00%
P/E Ratio 16.67
parison with our earlierresults for Firms A and
B is facilitatedby expressing the three compo-
nents of return as a percentage of the original
price of $250. Thus, while Firm D's dividend of
$5 is higher than the dollar value of Firm A's
dividend, it represents a lower dividend
yield-2 per cent, compared with 4 per cent for
Firm A.
Figure I compares the yearly dividends of
Firm A and Firm D (as a percentage of the
original price). Despite the rapid 10 per cent
growth of Firm D, the dividends of Firm A
continue to dominate for many years. An inves-
tor in Firm D, however, should expect yearly
price increments to keep pace with the 10 per
cent growth in book value and earnings that
Firm D experiences. Thus, over the course of
one year, Firm D's 2 per cent dividend yield
combined with a 10 per cent price gain will
provide a new investor with the 12 per cent
market return.
Figure J compares the dividend and price
increments for Firms A and D. The 10 per cent
annual price return of Firm D is sufficient to
bring the combinationof its dividends and price
increments (expressed as a percentage of Firm
D's initial $250 price) to a level that completely
dominates the dividends and price increments
for Firm A.
We can compareFirmD's stock to a perpetual
bond. In the absence of risk, Firm D's stock-
like that of FirmA-is equivalent to a perpetual
bond with increasing principal. The only differ-
ence is that the coupon is now 2 per cent and the
principalincreases by 10 per cent per year.
Total Growth
We complete our comparisonof the two firms
by considering the totalportfolio growth that an
investor in FirmD can be expected to receive. A
fully compounding investor in Firm D will cre-
Figure I A Comparison of the Dividends of Firm D and Firm A*

100% DDividendof FirmD (10%growth)

80 * Dividendof FirmA (8%Growth)
60

40-
20
O~
0 5 10 15 20
Year

*As percentageof original price.

ate a side pool of wealth that compounds at the for FirmA. This price reflects bothFirmD's high
assumed 12 per cent market rate. current earnings and the expectation of future
Because dividends for Firm D represent a above-marketinvestment opportunities. By vir-
relatively small percentage of the initial invest-
tue of its business franchise, Firm D has the
ment, this side pool will grow more slowly than special opportunity to reinvest a portion of its
it would for an investment in the other firms. In
earnings at the above-market, 15 per cent rate.
fact, the side pool for FirmD grows just enough,This opportunity is not directly available to
in comparisonwith that of FirmA, that when all investors because, in our equilibrium model,
the components of return are considered, the investors are able to achieve only the 12 per cent
period-by-period returns for the two firms are marketreturn.
identical (see Figure K). In contrastto FirmA, FirmD is able to achieve
In the context of our narrow model, the a 3 per cent return advantage on a prescribed
positive impact of the combination of growth stream of future investments. This excess 3 per
and high ROE is not on return, but on the P/E cent returnproduces a pool of incrementalvalue
ratio. It is this ratio that reflects both current
beyond what the investor could achieve with his
earnings and embedded future franchiseoppor- externalside pool. This compounding stream of
tunities. To understand better how this works, excess returns will have real value to the inves-
we will now look "inside" the P/E ratios of the tor, and he will naturally "pay up" to access it.
sample firms. The value of the excess returns is reflected in
the PilEratiofor FirmD. Because this firmearns
A Closer Look at the Investment Process $15 the first year, its P/E is 16.67 ($250/$15).This
We observed above that FirmD's stock is priced is twice the P/Eratio of the other firms. In effect,
at $250, compared with an initial price of $100 FirmD is priced at a premium of 8.34 above and

Figure J Annual Dividends and Price Appreciation for Firm D and Firm A*

100% m PriceChange
80 EIDividend of FirmD (10%growth)
$ 60 * Dividendof FirmA (8%growth)
40

20

0 5 10 15 20
Year

*As percentageof original price.

19900n26
FINANCIALANALYSTSJOURNAL/ NOVEMBER-DECEMBER
Figure K A Comparisonof Year-by-Year
Returnsfor FirmD and FirmA*

100% Intereston Interest

80 _ PriceChange
60 lI Dividendof FirmD (10%growth)
*Dividend of FirmA
, 4U L (8%growth) l
20
0 5 10 15 20
Year

*Aspercentage
of originalprice.

beyond the base P/E of 8.33. This P/E increment value may be viewed as consisting of the origi-
can be interpreted as a premium for franchise nal $100 (the base source of earnings at the
opportunities. outset) and a $10 new investment (a source of
Figure L compares the P/E ratios of Firms A, "new earnings").This new $10 per share invest-
B, C and D. As we have alreadyobserved, when ment will, by assumption, produce returns at
the ROEis the same as the marketrate (FirmsA the 15 per cent ROElevel in perpetuity.
and B), the P/E always remains at its base level, The year-end reinvestment of $10 can itself be
regardless of the firm's payout policy or growth viewed as achieving a 3 per cent premium
rate. When a firm has an above-marketROEbut return over the 12 per cent market rate because
no growth (Firm C) it too offers only the base of some special franchise situation enjoyed by
P/E. A growth firm with an above-market ROE FirmD. As we saw in the comparison of Firms
(FirmD), however, will have a P/E that is higher A and B, reinvestment at the 12 per cent market
than the base P/E of 8.33. (It should also be rate provides no added value to the investor: It
noted that a growth firm with a below-marketwill not lead to any increment in the P/E multi-
ROE will have a P/E ratio below8.33.) ple. The real added value from FirmD is derived
totally from the 3 per cent excess return that it
Source of Premium can earn on its new investments.
To see how this premium value is created, we Because, by assumption, all new investments
must focus more closely on the reinvestment provide 3 per cent in excess earnings in perpe-
process. After one year, Firm D pays out $5 of tuity, FirmD provides a compounding streamof
its $15 in earnings as dividends and retains and incremental earnings. In the second year, the
reinvests the remaining $10. As a result, the retained earnings available for new investment
firm's book value grows to $110. The new book will grow to $11 (that is, 1.10 x $10). In the third

Figure L The P/E Ratios for Firms A, B, C and D

16.67

8.34

A B C D
ROE 12% 12% 15% 15%
PayoutRatio 33-1/3 100 100 33-1/3
GrowthRate 8 0 0 10

1990 LI27
FINANCIALANALYSTSJOURNAL/ NOVEMBER-DECEMBER
year, Firm D has $12.10 (that is, $10 x 1.102)to offer in excess of the market rate. The firm can
invest. Over time, this sequence of opportuni- always raise new funds through the issuance of
ties produces a growing aggregate stream of additional equity, paying the market rate for
excess earnings. such funds. It therefore does not matter
If we were to calculate the present value of whether new investments are funded by re-
this compounding stream of excess earnings, tained earnings or by additional equity issu-
we would find that it amounts to $125 per ance. (In this analysis, we deal with the unlever-
share-that is, 50 per cent of Firm D's price aged firm. For this reason, we do not address
according to the DDM. The other 50 per cent of the obviously realistic alternative of debt fi-
Firm D's value is simply derived from its full- nancing for new investment opportunities.)
payout equivalence to Firm C. (Recall that the The stream of all future franchise opportuni-
price of Firm C's stock is precisely $125.) In ties implied by the DDM can be encapsulatedin
summary, Firm D can be viewed as a combina- a single number-G, the present-value Growth
tion of the following-(1) a full-payout- Equivalentof these investments. The present
equivalent firm, such as Firms A, B and C, and value of the Growth Equivalentcan be derived
(2) a stream of opportunities for investment at 3 by discounting all future franchiseopportunities
per cent above the market rate. at the marketrate and then expressing the result
We've seen that all full-payout equivalents as a percentageof the originalbook value of the
have the same P/E ratio in a given market-8.33 firm.9 The Growth Equivalent enables us to
at the assumed 12 per cent marketrate. FirmD's view the stream of future opportunities as
P/E ratio of 16.67 can now be viewed as consist- equivalentto a single, immediate opportunityto
ing of this base value of 8.33 plus an incremental invest and then earn the ROE in perpetuity. In
P/E multiple of 8.34 for its stream of excess other words, we are reducing all growth pat-
earnings on new investments. terns to the simple model of a single, immediate
jump in book value. The Growth Equivalentis
The Present-Value Growth Equivalent quite general; it can represent any sequence of
A firm's opportunities to earn returns in excess opportunities.
of the equilibriummarketrate can be thought of The Growth Equivalentapproach can help to
as "franchisegrowth opportunities." The tradi- penetrate the facade of smooth growth that
tional DDM implicitly assumes that a firm al- often obscures the real implications of many
ways has the opportunity to make investments DDM models. The Growth Equivalentthus pro-
that offera returnequal to the firm'sinitialROE. vides insight into the magnitude of the invest-
The DDM also implicitly assumes that such ment implicit in any given constant-growth as-
investments are made along a smooth growth sumption.
pattern determined by the firm's sequence of
retained earnings. Immediate Investment vs. Serial
It is clearly more realistic to assume that Investment
franchise opportunities arise on a less-than- As an example, consider Firm D. Recall that
its P/E is at an 8.34 premium to the base P/E of
regularschedule. Furthermore,there is no guar-
8.33. Basically, this incremental multiple is the
antee that the extent of the franchise opportu-
nity will equal available cash. A firm will value attached to the growing sequence of op-
portunities to invest at 3 per cent above the
nevertheless want to take full advantage of any
opportunities to earn above-market returns- market rate. As we observed above, this se-
whether or not the opportunities happen to quence coincides with Firm D's pattern of re-
coincide with the timing or magnitude of the tained earnings.
firm's retained earnings. In today's capitalmar-By computing the Growth Equivalent of this
series of investments, we find the magnitude of
kets, a firm should always be able to raise the
the single, immediate opportunity that provides
capital needed to fund projectsthat offer excep-
the same present value as the smooth growth
tional returns. We thus assume that the firmwill
pattern associated with Firm D's retained earn-
fully utilize all franchise opportunities, and that
ings. It turns out that this equivalent invest-
the cost of capital will be the assumed market
rate.8 ment, G, correspondsto 500 per cent of FirmD's
As we have shown, the value of new invest- current book value.10 In present-value terms,
ments is derived solely from the return they Firm D must immediately invest an amount

FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER 1990 O 28

Figure M The Present-ValueGrowthEquivalentfor a 10 PerCent GrowthFirm

$1800

1200 Present-Value Growth Equivalent

Book
Value

10 Per Cent Annual Growth

100
0 I* I * I I I I .,I
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30

Year

equal to five times its current book value and
earn 15 per cent on that investment in perpetu-
ity.
Figure M illustrates how FirmD's book value
increases by larger and larger increments by
virtue of actual growth at the 10 per cent annual
rate. It also shows the hypothetical book value
of the corresponding Growth Equivalent. Both
cases start with an original book value of $100.
For the Growth Equivalentfirm, however, book
value immediately jumps by $500, to $600, and
remains constant at this level.
The Growth Equivalent approach creates a
hypothetical "alter ego" for any growth firm.
After the immediate jump in book value, the
alter ego has no furthergrowth. Becauseit does
not have further growth, it retains none of its
earnings, and all net flows are paid out imme-
diately as dividends. Consequently, the alter
ego can be viewed as an "augmented" full-
payout equivalent of a growth firm. This can be
seen more clearly in Figure N, which compares
the dividend flows from the growing Firm D
with the constant dividend payments of its
full-payout alter ego.
The payouts for Firm D begin with the initial
dividend of $5 (2 per cent of $250) and grow at
a constant rate of 10 per cent forever. In con-
trast, the GrowthEquivalentprovides an annual
payout consisting of (1) the original $15 of
earnings (that is, the full-payout equivalent),
augmented by (2) an additional $15 from the 3
per cent excess return (= 15% - 12%) on the
$500 GrowthEquivalentinvestment. This hypo-
theticalGrowth Equivalentthus provides a con-
stant annual payout of $30 in perpetuity. When
discounted at the market rate, both cash flows
have the same present value of $250.
The expected level of above-market-ratein-
vestments implicit in a P/E of 16.67 is startling.
For a start-up firm with a new product and an
incontestable franchise, it is probably not too
difficultto imagine several years of spectacular
investment opportunities. But it must be dif-
ficult for a mature, large company in a highly
competitive market to find an opportunity to

Figure N A Comparison of the Cash Flows of a 10 Per Cent Growth Firm with a Growth-Equivalent Firm

$210
180 E ExcessEarningsfroma $500
Growth-EquivalentInvestment
150 -
120 -Original Earnings
;-T
90 10%DividendGrowth
~n 90
U 60
-a~ ~ ~ ~~~~~Ya
00 10 20 30

FINANCIALrANALYSTS JOURNAL / NOVEMBer

FINANCIALANALYSTSJOURNAL/ NOVEMBER-DECEMBER
1990El 29
Figure 0 The Franchise Factor
4.0
3.5
3.0 _
? 2.5 _
2 2.0 _
4 1.5 _
CZ 1.0 _
W-
0.5_
0.0 I I
12 14
ROE(%)
invest five times its currentbook value and earn
a return significantly higher than the market's.
The Franchise Factor
As we have seen, firms that offer both growth
and above-market ROEs are valued at a pre-
mium to the base P/E. To measure the impact of
above-marketinvestments on P/E ratio, we in-
troduce a new measure, called the Franchise
Factor (FF). The FF is the increase in P/E that
results from one unit of present-value Growth
Equivalent.
In a stable market,the FFdepends only on the
firm's ROE. Computationally, the FF is the
return premium offered by the firm divided by
the product of the ROEand the marketrate (see
the appendix for the derivation of the FF):
r- k
FF =
rk
where r is the firm'sROE,k the marketrate, and
all values are expressed as decimals.
To understand how the FF works, consider
Firm D. Because the ROEis 15 per cent and the
marketrate is 12 per cent, the FFfor this firm is:
0.15 - 0.12 0.03
FF= - = 1.67.
(0.15)(0.12) 0.018
Firm D's P/E will increase 1.67 units for each
unit gain in book value (in present-valueterms).
We have already seen that the present-value
Growth Equivalentfor Firm D is 500 per cent of
book. As a consequence of the FF, FirmD's P/E
ratio is lifted 8.34 (= 1.67 x 5) units above the
base P/E ratio, to a total level of 16.67.
We can express P/E ratio in terms of the
marketrate, the Growth Equivalent(G) and the
FranchiseFactor (FF), as follows:
FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER 1990 O 30
I I
16 18 20
1
P/E=-+FF G, or
k
P/E = (Base P/E) + FF *G.
The first term is the base P/E. The second term
is the product of the Franchise Factor and the
Growth Equivalent. This term captures the in-
crease in the P/E ratio that results from the
combinationof growth and above-marketROE.
We have already observed that, in a stable
market, the FF depends only on the ROE. G
depends only on the assumed growth rate.
Thus the FF and G fully-but separately-
capture the impact of ROE and growth on P/E
ratio.
ROE, Growth and P/E
Figure 0 illustratesthe FF for a wide range of
ROEs.When the ROEis the same as the market
rate, the FF is zero. As a result, growth makes
no contributionto the P/Eratio. Recallthat Firm
A had 8 per cent growth but an ROEonly equal
to the market's. The FF for FirmA is thus zero.
As we observed earlier, growth without incre-
mental ROE makes no contributionto P/E.
Now consider a firm with an FF of one (that
is, reading from Figure0, a firmwith an ROEof
13.64 per cent). For such a firm, an immediate
investment equal to 100 per cent of currentbook
value lifts the P/Eratioby only a single unit (that
is, from 8.33 to 9.33). The magnitude of this
immediate investment illustrates the growth re-
quired to raise the P/E ratio. With an FF of four
(that is, an ROE of 23.08 per cent), an invest-
ment equal to 100 per cent of book raises the P/E
ratio by only four units. This analysis under-
scores the difficultyinherent in creating a high
P/E ratio.
Table V The P/E Ratios and FranchiseFactorsfor FirmsA, B, C and D

Growth Growth Franchise PIE

Firm ROE Rate Equivalent Factor Increment PIE
A 12% 8% 200% 0 0.00 8.33
B 12 0 0 0 0.00 8.33
C 15 0 0 1.67 0.00 8.33
D 15 10 500 1.67 8.34 16.67

As ROE increases, so does the FF. As we
would expect, the higher the ROE, the greater
the impact of new investments on P/E. How-
ever, as Figure 0 shows, this impact eventually
levels off. In particular, as ROE approaches
infinity, the FF approaches the inverse of the
market rate. With our assumed 12 per cent
marketrate, this implies that a 100 per cent (one
unit) increase in book can never increase P/Eby
more than 8.33.
Table V summarizes our findings. Because
Firms B and C have no growth, their Growth
Equivalentis zero. By contrast, FirmA has a 200
per cent Growth Equivalent, and Firm D has a
500 per cent Growth Equivalent.However, Firm
A's growth fails to add value, because its FF is
zero (its ROEbeing the 12 per cent marketrate).
In addition, observe that Firm C may have
untapped potential: It has the same FF as Firm
D, as it has the same 15 per cent ROE. Yet,
because of a lack of new investment, Firm C's
potential is not utilized, and it commands only a
base P/E. Only Firm D, with its combinationof
positive growth and positive FF, is able to
command a premium P/E.
Figure P presents a more graphicview of how
the FF and Growth Equivalent explain the P/E
levels of our four firms. When the P/Eis plotted
against the Growth Equivalent, all firms that
have the same ROE plot along a straight line.
This line always starts at the base P/E ratio (8.33
in our example). The slope of the line is just the
FF for that ROE. Thus firms with a 12 per cent
ROEhave an FF of zero and plot as a horizontal
line. Firmswith a 15 per cent ROEplot along the
line with a slope of 1.67.
In this diagram, Firm A has 200 per cent
growth, but it is on the horizontal (FF = 0) line.
It thus commands only the base P/E of 8.33.
Firms B and C have no growth, hence they too
can obtain only the 8.33 base P/E (regardlessof
their ROE or FF values). Only Firm D has the
right combination of growth (a 500 per cent
Growth Equivalent)and an above-marketROE
(15 per cent). It lies on the line with a slope (FF
value) of 1.67, hence enjoys a high P/E ratio.
Figure P also shows how firms with a 20 per
cent ROE plot. As we can see, a high ROE
certainly makes growth more valuable. At the
same time, to obtain a high P/E ratio, even with
an ROE significantly above the market, a firm
must possess rather sizable growth prospects.
Conclusion
We have represented all above-market invest-
ment opportunities implicitly embedded in the
DDM by their present value. In so doing, we are
able to look beyond a pattern of either smooth

Figure P Interpreting the P/E Ratio through the Franchise Factor

FF = 3.33; ROE= 20% .

42 16.67 S. -
ff.- ~~D
..8.33
8.33
.--~~~
.. ~
< FF =0.00; ROE=12%
A
B and C
I I I I I
0 100 200 300 400 500 600
GrowthEquivalent(%)

FINANCIALANALYSTSJOURNAL/ NOVEMBER-DECEMBER
1990 31
constant growth or multiphase growth. The Financial Analysts Journal, September/October
analysis can thus readily be extended to incor- 1986 and "A Total DifferentialApproach to Eq-
porate an entire portfolio of investment oppor- uity Duration," FinancialAnalysts Journal,Sep-
tunities. Each investment can have its own tember/October 1989.
7. Fora study that relates the DDM approachto the
(possibly irregular)capital schedule, return pat-
price-to-bookratio, see T. Estep, "A New Model
tern and life cycle. for Valuing Common Stocks," FinancialAnalysts
In reality, taxes, leverage and uncertaintydo Journal,November/December1985.
exist, and prices do not coincide with theoretical 8. It is more realistic to assume that franchise op-
values. Market rates, investment opportunities portunitieswill offer a range of returns. For ease
and year-to-yearROEschange constantly. Thus of exposition, we consider only the case where
our results, derived under highly simplistic as- the return is equal to initial ROE.
sumptions, must be interpreted with appropri- 9. Fora constant growth rate, g, and marketrate, k,
ately large caveats. They nonetheless appear to G = g/(k - g). See the appendix for a derivation
provide valuable insights into the structural of this formula.
relations inside the P/E ratio. U 10. Since G = g/(k - g) and g = 10 per cent for Firm
-
D, it follows that G 0.10/(0.12 - 0.10) = 500 per
cent.
Footnotes
1. See, for example, J. B. Williams, The Theoryof Appendix
InvestmentValue(Cambridge,MA: HarvardUni- According to the standard dividend discount
versity Press, 1938);M. J. Gordon, TheInvestment model (DDM), a theoretical stock price is com-
Financingand Valuationof the Corporation (Home-
puted by discounting the stream of all future
wood, IL: RichardD. Irwin, 1962);M. H. Miller
and F. Modigliani, "Dividend Policy, Growth, dividends at the market rate, k. Thus:
and the Valuationof Shares,"Journalof Business, Di D2 DN
October 1961. For a current update on dividend P = ~+ 2 +**+ N+...
discount models, see the November/December
1985 issue of FinancialAnalystsJournal. where
2. We thank R. Merton for his many insightful
comments regardingthe "franchise"concept. For Di= dividend at time i.
a discussion of the duration of franchise oppor-
tunities and the driving forces behind them, see
If we assume that dividends grow annually at
J. L. Treynor, "The Elements of Investment Val- a constant rate g, then P can be shown to be:
ue" (Paperpresented at BrighamYoung Univer- Di
sity, October 13, 1983). P= (Al)
3. The FranchiseFactorand Growth Equivalentare -k g'
consistent with the net present value concept. This is the standard Gordon formula. Note that
For a detailed discussion of the latter, see R. A. this was derived without regardto the source of
Brealey and S. C. Myers, Principlesof Corporate
dividend growth.
Finance(New York:McGraw-Hill,1988).
4. For fixed income securities, the realized com- Dividend growth is related to a firm's return
pound yield or total return incorporatesall the on equity (ROE) and to the growth in book
components of return. This concept is discussed value that results from retained earnings. To see
in S. Homer and M. L. Leibowitz, Insidethe Yield this, note that the dollar dividend payout at
Book(Englewood Cliffs, NJ: Prentice-Hall,1972). time i depends on the firm's earnings over the
5. With fixed income securities, reinvestment is period from time (i - 1) to time i. These earn-
generally assumed to be in riskless assets, which ings are symbolized by Ei. The dividend payout
may offer a lower return than the originalinvest- is expressed as a fractionof earnings, called the
ment. Here dividends are reinvested in equity dividend payout ratio. Here we assume that the
assets that offer the same expected return as the dividend payout ratio is a constant b over time.
original investment.
Thus:
6. A detailed comparison of the total return on a
stock and the total return on a bond is provided Di = bEt.
in M. L. Leibowitz, "Bond Equivalentsof Stock
Returns," Journalof PortfolioManagement,Spring The earnings Ei are the product of the firm's
1978. For an in-depth discussion of equity dura- ROE and the book value Bi-1 at the beginning of
tion see M. L. Leibowitz, "TotalPortfolioDura- the period. We assume that the ROE is a con-
tion: A New Perspective on Asset Allocation," stant r, so that:

FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER 1990 O 32

Table Al Theoretical Stock Prices and P/E Ratios for Four Firms (12% market rate)

Specifications ResultingValues
Payout Initial PIE
Ratio ROE InitialBook Retention Growth Earnings Price Ratio
Firm (b) (r) Value(Bo) Rate(q) Rate(rq) (rBO) [brBJ(k-g)] tb/(k-g)1
A 1/3 12% 100 2/3 8% 12 100 8.33
B 1 12 100 0 0 12 100 8.33
C 1 15 100 0 0 15 125 8.33
D 1/3 15 100 2/3 10 15 250 16.67

Ej rB
lL _ji =J 1, 2, *(A2
.,N. )o
By algebraic manipulation, formula (A4) can
be transformed into the Miller and Modigliani
Because earnings are a constant multiple of (MM) formula. We first write:
book value, they will grow at the same rate as
book value. All earnings not paid out as divi- b 1-q
dends (that is, retained earnings) add to book P/E = =-
k-g k-rq
value. (Forthe moment, we assume there are no
other sources of additions to book, e.g., no new Factoringout 1/k, we have:
equity issuance.) The earnings retention rate q
1 Fk(l1-q)llFk-kql
is: P/E = - 1 = 1I
k k - rq k k - rqjl
q = (1 - b).
Subtractingand adding rq to the numerator of
If Bois the initialbook value, book value at the the term in brackets, we have:
end of the first year, B1, is:
1 k -rq +rq -kq
B1= Bo + qE1. P/E = -[k r k
k k - rq
Because E1 = rB0, we have:
Carryingout the indicated division results in the
B1= Bo + qrBo following MM formula:
= (1 + qr)BO. 1F q(r-k)1
+ I.
P/E = 11 (A5)
Thus book value grows at the rate qr. Because k L k -rqj
both earnings and dividend streams grow with If there is no growth (q = 0), the second term
book value, qr is the sustainable growth rate. in bracketsvanishes, and the P/E ratio is simply
That is: the inverse of the marketrate, regardless of the
g = qr = (1 - Payout Ratio) *ROE. value of r. Thus, for example, if q = 0 and k =
12%, P/E = 1/(0.12) = 8.33. Thus both Firms B
Note that the Gordon formula, Equation(Al), and C in Table AI have a P/E ratio of 8.33 (the
can be rewritten in terms of initial earnings and base P/E).
dividend payout ratio, as follows: If q is greaterthan 0, but the return on equity
r is the same as the market rate k, the second
bE1
P= (A3) term above still vanishes. Again, P/E = 1/k.
k - g' Thus, because r = 12%for FirmA, it also has a
base P/E of 8.33.
The theoretical P/E ratio is thus:
For the P/E to rise above the base P/E, we
b must have both growth and reinvestment at an
P/E =
k .g (A4) above-market ROE. Growth alone is not
enough. For Firm D, where q = 2/3 and r = 15%,
Table Al provides four examples-the four the P/E ratio is 16.67.
firms discussed in the text-illustrating the pric- Additional insight into the nature of growth
ing and P/E ratio formulas given above. In all can be gained by rewriting Equation (A5) in
cases, we assume that the marketrate k is 12 per terms of price and initialbook value, ratherthan
cent. P/E. We thus multiply both sides of Equation

1990C 33
FINANCIALANALYSTSJOURNAL/ NOVEMBER-DECEMBER
(A5) by E and replace E by rBo in the second
term:
E qrBo(r- k)
k k(k - rq)'
or
E r-k g k - g'
P=-+~~~
k k (k- g) -*Bo.
The first term in Equation(A6) represents the
present value of a perpetual stream of unchang-
ing earnings of magnitude E. In other words,
this term corresponds to a firm's full-payout
equivalent. The second term can be shown to
represent the earnings impact of a series of new
investments. The magnitude of these new in-
vestments is Bo0 g/(k - g). The factor g/(k - g)
can be interpreted as an immediate percentage
increase in book value. Thus we set
G=(k g)
and regard G as the present-value Growth
Equivalentof all book increases. (See below for
a more detailed discussion of G.) The new
investments, G *Bo, provide perpetual incre-
mental above-market earnings of (r - k). The
present value of this perpetual stream is ob-
tained by dividing (r - k) * G * Bo by k.
Equation (A6) can be rewritten in terms of G
as follows:
E r-k
P = k + k *G*Bo.
k k
We now show that G is, in fact, the present
value of all future investments implied by the
DDM model, expressed as a percentage of Bo.
The firm's book value at time i, Bi, is:
Bi= (1 + g)'Bo.
The increment to book at time i is symbolized by
bi and is equal to Bi - Bi-1. Thus:
bi = Bi - Bi- 1 = (1 + g)'Bo - (1 + g)'- 'Bo,
or
bi = (1 + g)'1- gBo.
The present value of all such book increments
is as follows:
PV ri-, i-, i- . I gBo gBo(1+ g)
FINANCIALANALYSTSJOURNAL/ NOVEMBER-DECEMBER
gBo(1+ g)2
(1 + k)3
gBo F 1+g (1+g)2
=. 1+ ++ _ +
l +k [ 1+k (?+k)2
gBo
(A6)
Thus
PV [b1, b2, b3,.*.] g
Bo k- g
This is preciselyG as defined above. Note that G
is independent of the funding of the book value
increments. That is, the assumption that only
retained earnings are used to fund new invest-
ments is artificial.If an opportunity to invest bi
and earn r exists at time i, this investment could
be funded through the issuance of equity at a
cost k. The earnings on this new investment,
(A7) net of financingcosts, would then be precisely (r
k).
We further note that it is the magnitude of
G-not the specific timing of investment oppor-
tunities-that matters. That is, a different se-
quence of book increments b1*,b2*, b3, . . . for
which PV[bl*, b2*, b3*, . . . ]/Bo is equal to G,
would have precisely the same impact on the
theoreticalprice as the sequence of book incre-
ments implied by our constant-growth model.
As an example of the magnitude of growth G
implicitin the DDM, consider FirmD. Since g =
10%and k = 12%,G is (0.10)/(0.02),or 500 per
(A8)
cent! For this firm to sustain a P/E ratio of 16.67
(Table Al), there must be some sequence of
investments that, in present-value terms, is
equal to 500 per cent of the currentbook value of
the firm. Furthermore, each of these invest-
ments must earn 15 per cent. These extraordi-
nary opportunities are reflected in the firm's
price through the present value of the excess
returns on those investments, as illustrated in
the Equation (A8).
For Firm D, because r = 15%, Bo = $100 and E
= $15, we have the following:
15 0.15 - 0.12
0.12 0.12 *500%*100
= 125 + 125 = 250.
Thus the value of the present earnings of $15 in
perpetuity is $125, and the value of all future
excess earnings is also $125.
1990 O 34
Table All FranchiseFactorsfor VaryingROEs(with a 12%marketrate)

ROE(r) 12% 13% 14% 15% 16% 17% 18% 19% 20% 50%
FF 0.00 0.64 1.19 1.67 2.08 2.45 2.78 3.07 3.33 6.33

To understand better the impactof G, we turn BO),FF is the increase in P/E ratio per "book
our attention to the P/E ratio. By dividing both unit" of investment.
sides of Equation (A8) by E (that is, by rB0),we Note that, when r = k, FF = 0. This is
obtain consistent with our earlier observation that
1 r-k growth alone is not enough to affect the P/E
P/E=-+- *G. (A9) ratio. However, as r increases, the impact of
k rk growth on P/Eincreases. These results are illus-
The first term, 1/k, is the "base P/E"(that is, P/E trated in Table AII.
= 8.33 when k = 12%). If the second term is Consider, for example, the case of Firm D.
positive, the P/E will be above this base level. If Because r = 15%, FF = 1.67. An investment
that term is negative, the P/E will be below the equal to 100 per cent of this firm's initial book
base P/E ratio. value (that is, $100)will lift the P/E ratio by 1.67
The factor (r - k)/rk measures the impact of units. An investment of five times book will lift
opportunities to make new investments that the P/Eratioby 8.34 units-just enough to bring
provide a return equal to the firm's ROE. We it from the base P/E ratio of 8.33 to its actual P/E
call this the FranchiseFactor, or FF. Thus ratio of 16.67.
FF = (r - k)/rk (A10) Finally, we observe that, as r approaches
infinity, FFlevels off at the inverse of the market
and rate k. That is, no matter how large the ROE,
1 with a 12 per cent marketrate, FFcan never rise
P/E=-+FF*G. (All) above 8.33. In particular,at least a 100 per cent
k
increase in book is requiredto raise the P/Eratio
Because G is measured in units of initial book from 8.33 to 16.67, no matter how large the
value (that is, G is expressed as a percentage of reinvestment rate.

FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER1990 O 35