Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

EVALUATING THE REASONABLENESS OF A P/E

Equation 8.8 can be rearranged to write the P/E as a function of θτ and k:

(8.11)

Equation 8.11 says that when k is held constant, the P/E will increase as the value of θτ increases. In a competitive market, the firm cannot earn economic profits, so θτ = 1. If the implied value of θτ is greater than 1, some type of firm or industry characteristic must be allowing the firm to invest in new positive-NPV projects. Porter (1980, 1985) gives the following insights into the characteristics consistent with a value of θτ > 1.

First, the industry should be growing, or the firm should be able to expand into related industries that are growing. Earning a positive NPV by simply increasing market share is difficult. To steal market share from competitors, a firm may have to slash prices, thus reducing margins and investment returns.

Second, the firm should have a competitive advantage that will allow it to earn investment returns of RN > k in the new market. The firm could have a superior product, which would allow it to charge a premium price, or the firm could have a cost advantage, which would allow it to earn economic profits without charging a premium price.

Third, the intensity of competition in the new market should be low. If the intensity of competition is low, the firm will have a better chance of earning returns of RN > k. The intensity of competition ...