Profit and Loss Account/Income Statement
Revenues (or Sales)
100
Less:Cost of Goods Sold
75
Gross Margin /Gross Profit
25
Less: SG &A expenses
15
Operating Profit/EBIT
10
Less: Interest
5
EBT
5
Less: Taxes (@40%)
2
Earnings after tax/Net Income
3
PE Ratios
Earnings are what the income statement calls net income Earnings per share (EPS) Return on Equity: NI (or earnings) divided by last year's book equity Sometimes people use this year's BE, but that makes less sense What can I do with earnings? Pay them out (Dividends) Reinvest them. If reinvested they are added to book equity P/E of 10: when you buy the stock, you pay $10 for every dollar of earnings the company generates
GGM
Suppose I reinvest a fixed proportion "b" of my earnings Plowback ratio or reinvestment ratio Then how much did I pay out as dividends this year? Next year? Hence, if price is at fair value and GGM applies then: Forward P/E: -Trailing P/E:
Higher PE ratios
Lower the r: - Lower beta - Lower rf Lower market risk premium Higher the dividend growth (or earnings growth, g is both) Lower the plowback ratio b
Example
In Dec 1999, companies "like" Texas Instruments (TXN) were trading at forward P/E ratios of 3 Suppose GGM applies Suppose beta= 1.2, so r=9% The payout ratio was known to be 0.13. What is the retention ratio b? What is the market's (implicit) estimate of Texas Instrument's growth rate?