Corporate and Project Finance Modeling

Chapter 34Computing Implied Price/Earnings Ratios for Use in Terminal Value Calculations

If you spend time watching financial analysts on television sounding highly intelligent in expressing their opinions about the value of a stock, they generally pontificate about both the projected earnings and the valuation. Most of the time the analysts make some kind of earnings projection (more often than not optimistic) and then employ a future price/earnings (P/E) ratio to the projected earnings to arrive at what they think the future stock price will be. What they have done is estimate equity cash flow rather than free cash flow and then apply a terminal valuation using the P/E ratio. When the analysts go on about the future earnings multiplied by the P/E, they are talking about terminal value while the dividends received during the intermediate period are like the explicit free cash flows. These valuations are analogous to all of the discounted cash flow (DCF) discussion in previous chapters except the analysis is made with equity cash flow rather than free cash flow. In computing the equity value using a future P/E ratio, the financial analysts often seem to have some kind of magical way to project the future P/E ratio that drives the valuation.

The next two chapters discuss techniques to evaluate P/E and enterprise value/earnings before interest, taxes, depreciation, and amortization (EV/EBITDA) multiples for purposes of computing terminal value, and take some mystery out of the ...