Introduction to Corporate Finance

PARt 2: VALUAtIoN, RISk ANd REtURN

There is one other important consideration when you use multiples to perform valuation analysis: when the

denominator of a ratio is small, the overall ratio becomes large. For example, if earnings fall to $0.01 for one

comparable company, then its P/E ratio might be very large (if the price is $20, then its P/E multiple would be

2,000 (= 20 ÷ 0.01)) and also vary greatly with small movements in the denominator (if earnings increased to

$0.10, the PE multiple would become 200). Smart analysts watch for extreme outliers, like a P/E ratio of 2,000,

and when extreme values appear in a sample of comparables, they exclude the outliers or use the median

value for the group rather than the average.

CONCEPT REVIEW QUESTIONS 5-4

6 Why might the terms book value and liquidation value, used to determine the value of a company,

be characterised as viewing the company as ‘dead rather than alive’? Explain why those views are

inconsistent with the discounted cash flow valuation models.

7 When comparing P/E ratios of different companies, analysts sometimes say that companies with

higher P/E ratios are expected to grow faster than companies with lower P/E ratios. What is the

discounted cash flow basis for this statement? Use a discounted cash flow argument to illustrate

how two companies that are expected to grow at the same rate might still have different P/E ratios.

5-5 PRIMARY ANd SECoNdARY MARkEtS

FoR EQUItY SECURItIES

In this section, we look at how shares are sold to investors in the primary market, and how investors trade

shares with each other in the secondary market. As previously noted, the primary market refers to the

market in which companies originally issue new securities. Once the securities have been issued in the

primary market, investors can trade them in the secondary market.

5-5a INVEStMENt BANkING FUNCtIoNS ANd tHE PRIMARY

MARkEt

Investment banks play an important role in helping companies raise long-term debt and equity

financing in the world’s capital markets. Investment banks sell new security issues and assist

and advise corporations about major financial transactions, such as mergers and acquisitions, in

exchange for fees and commissions. The three principal lines of business of an investment bank

are:

1 corporate finance

2 trading

3 asset management.

LO5.5

example

investment banks

Financial institutions that

assist companies in raising

long-term debt and equity

financing in the world’s capital

markets, advise companies

about major financial

transactions and are active

in the business of selling and

trading securities in secondary

markets

Considering the banking industry,

do you think that the mix of bank

investments in company loans

and asset holdings is likely to

remain the same for the next five

years? Why or why not?

thinking cap
question