Pinnacle Manufacturing Company Case Study
1. What do you expect to drive a company’s price-to-book equity and price-to-earnings multiples?
PE ratio is expected to be affected by various factors include company earnings, payout ratio, growth rate and cost of equity. From the dividend discount model we know that P0=EPS0×Payout ratio×(1+gn)r-gn , thus P0EPS0=PE ratio=Payout ratio×(1+gn)r-gn. Thus we see that the PE ratio is an increasing function of the payout ratio and the growth rate and a decreasing function of the riskiness of the firm.
The determinants of PBV ratio can also be explored by using the dividend discount model. We know thatP0=DPS1ke-gn, substituting for DPS1 =EPS1(payout ratio), the value of the equity can be written as: P0=EPS1×Payout ratioke-gn, Defining the return on equity (ROE)= EPS1/Book value of equity0,the value of equity can be written as P0=BV0×ROE×Payout …show more content…
ratioke-gn. This formulation can be simplified to the follow: P0BV=PBV ratio=(ROE-gn)ke-gn. Thus, the price-book value ratio of a stable is determined by differential between the return on equity and its cost of equity. It the return on equity exceeds the cost of equity, the price will exceed the book value of equity; if the return on equity is lower than the cost of equity, the price will be lower than the book value of equity.
2. Match the price to earnings valuation multiples below with each of the four restaurant businesses discussed above. What is your reasoning for the matches you selected?
Company A: PE ratio of 9.6 is most suitable for company A. Question 1 shows how the reinvestment rate of the company and its dividend payout rate affect the PE ratio of the company. It can be seen from the question that company A is the largest company among the others 3 in term of the size and history. The company has over a thousand of store including franchisees and thus, the reinvestment need is less than the other 3 companies and hence the growth rate is consequently to be low comparatively.
Company B: High PE ratio of 34.5 is most suitable for company B.
it can be seen that company B currently is in the “golden period” with high reinvestment need as new restaurants are opened during current years. Its average guest check is currently the highest among the others. Given the high revenue and its new store rollout plan, the growth rate is consequently high and the PE ratio should be high.
Company C: PE ratio of 28 is most suitable for company C. Given the fact that company C is planned to open 14 new restaurants in the following year, the growth rate would be extremely high. However it can be seen that the profit margin of the company is low comparatively, considered the high reinvestment need and low profit margin, its dividend ratio would be very low or even none.
Company D: it can be seen that Company D is a medium size firm who owns over hundred restaurants. Its underlying risk would be low compared to company B and C. moreover the company reinvestment would be low as the company is planned to merger with small to medium-sized firm around the country and thus A PR ratio of 20 is most
suitable.
3. Match the price-to-book equity valuation multiple below with each of the four restaurant businesses discussed above. What is your reasoning for the matches you selected?
From 2uestion1 it has been discussed that return on equity and growth rate is the main factor to drive a company Price-to-book equity ratio. Therefore a PB ratio of 1 is most suitable for company A and D as the two company has less reinvestment need. PB ratio of 4.4 is most suitable for company B as the company has the highest revenue and highest reinvestment need and thus the growth rate. PB ratio of 3.9 is most suitable for company D because of C because of its high growth and low return.
PE ratio is expected to be affected by various factors include company earnings, payout ratio, growth rate and cost of equity. From the dividend discount model we know that P0=EPS0×Payout ratio×(1+gn)r-gn , thus P0EPS0=PE ratio=Payout ratio×(1+gn)r-gn. Thus we see that the PE ratio is an increasing function of the payout ratio and the growth rate and a decreasing function of the riskiness of the firm.
The determinants of PBV ratio can also be explored by using the dividend discount model. We know thatP0=DPS1ke-gn, substituting for DPS1 =EPS1(payout ratio), the value of the equity can be written as: P0=EPS1×Payout ratioke-gn, Defining the return on equity (ROE)= EPS1/Book value of equity0,the value of equity can be written as P0=BV0×ROE×Payout …show more content…
ratioke-gn. This formulation can be simplified to the follow: P0BV=PBV ratio=(ROE-gn)ke-gn. Thus, the price-book value ratio of a stable is determined by differential between the return on equity and its cost of equity. It the return on equity exceeds the cost of equity, the price will exceed the book value of equity; if the return on equity is lower than the cost of equity, the price will be lower than the book value of equity.
2. Match the price to earnings valuation multiples below with each of the four restaurant businesses discussed above. What is your reasoning for the matches you selected?
Company A: PE ratio of 9.6 is most suitable for company A. Question 1 shows how the reinvestment rate of the company and its dividend payout rate affect the PE ratio of the company. It can be seen from the question that company A is the largest company among the others 3 in term of the size and history. The company has over a thousand of store including franchisees and thus, the reinvestment need is less than the other 3 companies and hence the growth rate is consequently to be low comparatively.
Company B: High PE ratio of 34.5 is most suitable for company B.
it can be seen that company B currently is in the “golden period” with high reinvestment need as new restaurants are opened during current years. Its average guest check is currently the highest among the others. Given the high revenue and its new store rollout plan, the growth rate is consequently high and the PE ratio should be high.
Company C: PE ratio of 28 is most suitable for company C. Given the fact that company C is planned to open 14 new restaurants in the following year, the growth rate would be extremely high. However it can be seen that the profit margin of the company is low comparatively, considered the high reinvestment need and low profit margin, its dividend ratio would be very low or even none.
Company D: it can be seen that Company D is a medium size firm who owns over hundred restaurants. Its underlying risk would be low compared to company B and C. moreover the company reinvestment would be low as the company is planned to merger with small to medium-sized firm around the country and thus A PR ratio of 20 is most
suitable.
3. Match the price-to-book equity valuation multiple below with each of the four restaurant businesses discussed above. What is your reasoning for the matches you selected?
From 2uestion1 it has been discussed that return on equity and growth rate is the main factor to drive a company Price-to-book equity ratio. Therefore a PB ratio of 1 is most suitable for company A and D as the two company has less reinvestment need. PB ratio of 4.4 is most suitable for company B as the company has the highest revenue and highest reinvestment need and thus the growth rate. PB ratio of 3.9 is most suitable for company D because of C because of its high growth and low return.