If the assumption that the relationship between P/E and
growthisnotlinear,wecouldeitherrunnonlinearregressions
or modify the variables in the regression to make the
relationshipmorelinear.Forinstance,usingthenaturallogof
thegrowthrateinsteadofthegrowthratein theregression
yields a more linear relationship.
Market Regression
Searchingforcomparablefirmswithinthesectorinwhicha
firmoperatesisfairlyrestrictive,especially whenthereare
relativelyfewfirmsinthesectororwhenafirmoperatesin
morethanonesector.Sincethedefinitionofa comparable
firmisnotonethatisinthesamebusinessbutonethathas
thesamegrowth,risk, andcash flow characteristicsasthe
firm being analyzed, we need not restrict our choice of
comparable firms to those in the same industry. The
regression approach introduced in the previous subsection
controlsfor differences on those variables that we believe
causemultiplestovaryacrossfirms.Basedonthevariables
thatdetermine eachmultiple,we shouldbe ableto regress
multiplesagainst thevariables that should affect them.As
shown in the previous section, the fundamentals that
determine each multiple are summarized inTable 7.3.
TABLE 7.3Fundamentals Determining Equity Multiples
Multiple Fundamental Determinants
Price-earnings ratio Expected growth, payout, risk
Price-to-book equity
ratio
Expected growth, payout, risk, ROE