Theprice-to-bookratioforthisfirmcanbeestimatedusing
the return on equity of 20% as an input:
This stock trades atwellabove book value,which should
comeasnosurprisesinceitsreturnonequityismuchhigher
than its cost of equity. The price-to-sales ratio can be
computed with the net profit margin (of 10%):
Basedonthisfirm’sfundamentals,wewouldexpectitsequity
to trade at 2.54 times revenues.
Relationship between Multiples and Fundamentals
In thepreceding section, we laidout equations that make
explicit therelationshipbetween the fundamentalvariables
thatdrivevalue—cashflows,growth, andrisk—and equity
multiples.Whenanalyzingcompanies,though,wearecalled
uponto makejudgments onhowdifferences ona variable
translateintodifferenceinamultiple.Forinstance,whilewe
can show fairly easily that, other things remaining equal,
companieswithhighergrowthshouldtradeathigherequity
multiples,weneedtobeexplicitabouthowthesemultiples