- The market capitalization is usually computed using the number of shares outstanding today (primary shares)
- The earnings per shares and book value per share are often computed using the potential number that can be outstanding if management options, convertibles, and warrants are exercised (diluted shares)
The Book Value of equity is the difference between the book value of assets and the book value of liabilities. There are firms with negative book values of equity - the result of continuously losing money - where price-to-book ratios cannot be computed.
- The value of growth lies in the future, and as interest rates rise, the value of expected growth decreases. Consequently, surprises about expected growth have a bigger impact when interest rates are low than when they are high
- The P/E ratio is much more sensitive to changes in expected growth rates when interest rates are low than when they are high
- If the firm is able to sustain high growth for longer period, all of the equity multiples will register higher values
- Holding other variables constant, increasing the risk of equity (beta) will decrease all equity multiples
- Not all growth is created equal, and companies that generate growth more efficiently (with less investment) should trade at higher equity values than firms that generate the same growth less effectively
Earnings growth rate = Retention ratio x Return on equity
- As the return on equity increases, the equity multiples all go up. At very low returns on equity, the firm will have to issue substantial new equity to sustain its high earnings growth, and the equity value per share decreases to reflect the potential dilution
- When the excess returns (difference between the return on equity and the cost of equity) are negative, the stock trades at below book equity
