Page 163 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes now you may recall that 'V' is the intrinsic value or the price at which the share would sell
if it were priced. Then, V/E would be the price-earnings ratio that must prevail if the
0
share were fairly priced. In other words, V/E would be the normal price-earnings ratio.
0
To obtain a normal price-earnings ratio from equation (7), divide both sides of the equation
by E and simplify. The resultant equation would be
0
V P (1 g ) P (1 g ) (1 g ) P (1 g ) (1 g ) (1 g )
1 e1 2 e1 e2 2 e1 e2 e3 ...
= 2 3 ..…(8)
E 1 K (1 K) (1 K)
0
You can now interpret equation (8) to show that a share's normal price-earnings ratio will
be higher: (g , g , g ……); the smaller the required rate of return (K).
e1 e1 e1
The above relationships are qualified by the phrase "other things being equal", which
means no change in variables. For example, the normal price earnings ratio would increase
with increase with increase in payout ratio but no company can ever achieve this result
concentrating on an increase in the payout ratio. What happens with an increased payout
ratio is a corresponding decrease in reinvestment of earnings and consequently a
diminution in the growth rate; increased payout would neutralized by decreased growth
so on. Consequently, intrinsic value and therefore the normal price-earnings will not
increase.
Second, equation (8) is based on the infinite series of dividends in the growth situations.
The equations can be derived as follows:

p 1 3 g
The Constant Growth Situation: V = ..…(9)
E K g
0
V 1
Zero Growth Situation:
E 0 K

Reasons for Company to have Negative Earning

There are a number of reasons for a company to have negative earnings. Some of the
reasons for negative earnings can be listed as follows:

1. Cyclical nature of industry
2. Unforeseeable circumstances
3. Poor management
4. Persistent negative earnings

5. Early growth stage
6. High leverage cost

Cyclical Nature of Industry

Companies might belong to the cyclical industry. When there is a recession in the economy,
the company will post negative earnings. However, once the economic variables change,
the companies in these cyclical industries also recover and show a positive growth rate.
Normalised Net Income = Average ROE * Current Book Value of Equity
Normalised after-tax Operating Income = Average ROC * Current Book Value of Assets

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