The Mathematics of Money

514 Chapter 12 Financial Statements

Example 12.3.7 Magnum Opus Corporation is considering buying a regional chain

of muffl er shops for $300,000,000. Last year, this chain earned $20,000,000, and the

owners’ equity is presently $85,000,000. Calculate the price-to-earnings and price-to-

book ratios at this proposed purchase price.

Price to earnings 

$300,000,000

_____________

$20,000,000

 15

Price to book 

$300,000,000

_____________

$85,000,000

 3.53

A company with a high price-to-earnings ratio is commanding a higher selling price for

each dollar of its earnings than a company with a lower PE ratio. Likewise, a company with

a high price-to-book ratio is more expensive relative to its owners’ equity than a company

with a lower price-to-book ratio.

When deciding a fair price for a company, investors must take into account not just the

present financial position of a company but also the company’s future growth prospects. Sup-

pose that you are considering investing in two companies, both of which earned $1.50 per

share last year. Both are solid and well-managed companies. One company is an established

grocery store chain, while the other is a rapidly growing biotechnology company. In all like-

lihood, you would expect to pay more for the biotech company because, even though both

companies have the same earnings today, the biotech company’s future earnings seem likely

to grow more quickly than the grocery chain’s would. In determining the appropriate PE ratio

for a business, investors take into account factors such as future earnings growth potential

and risks to the business. While there is no absolute way of determining what the PE ratio

should be, investors often look to the PE ratios of similarly situated businesses as a guide.

Example 12.3.8 Magnum Opus Corp. is considering buying out Southeastern

Neighborhood Apothecaries, a chain of retail pharmacies. Magnum Opus’ fi nancial

analysts have looked at the market prices of other similar pharmacies and found

that similar businesses sell at a PE of 18 on average. If Southwestern Neighborhood

Apothecaries is earning $6.5 million this year, what would be a reasonable price for

Magnum Opus to expect to pay?

PE  ____EarningsPrice

18  ___________Price

$6.5 million

Multiplying both sides by $6.5 million gives:

Price  $117 million

Of course this number is not absolute. Magnum Opus may be willing to pay more, or less,

depending on its business goals and objectives, and on the specifi c details of this particular

pharmacy chain that might make it command a higher or lower price. Magnum Opus may

also determine the price it is willing to pay on considerations other than earnings, such as the

value of the assets the company owns or the benefi ts that acquiring this business may offer

to the company’s overall business strategy.

Notice that in this example we ended up multiplying the company’s profits by the presumed

PE ratio. For this reason, the PE ratio is sometimes referred to as the earnings multiple.

The price-to-book ratio can be helpful in some situations, but can also be a misleading

measurement of the company’s value. Recall that the owners’ equity is meant to be a sort of net

worth of the company; the value of the business’s assets less its debts. A company that has a

book value per share of $17.53 might then be thought to have net assets worth $17.53 per share.

The difficulty with using this value, though, is the fact that, as we discussed in Section 12.2,

assets are listed on the balance sheet at cost or at depreciated cost, values that do not necessarily

match actual market value. Using the price-to-book ratio effectively as a valuation tool often

requires a bit of financial detective work, requiring an analysis of how closely the balance sheet

values of a business’s assets match up to the real market value of those assets.