As in our analysis of industry multipliers in Chapter 14, we use two approaches to estimate a company multiplier. First, we estimate the P/E ratio from the relationships among Walgreens, its industry, and the market. This is the macroanalysis. Second, we estimate a multiplier based on its three components: the dividend-payout ratio, the required rate of return, and the rate of growth. We then resolve the estimates derived from each approach and settle on one estimate.
Exhibit 15.5 and Exhibit 15.12 show the mean earnings multiple for the company, the RDS industry, and the aggregate market for the period 1977–2000. Notably, all these earnings multi- pliers are computed using future earnings. Walgreens’ relationship to its industry has changed dramatically over time. During the late 1970s and early 1980s, Walgreens’ multiplier was con- sistently below the industry’s. After 1987, the Walgreens multiplier has generally followed the industry multiplier with a company/industry ratio between 1.00 and 1.15. Similarly, the Wal- greens earnings multiplier was lower than the market multiplier until 1982 but they have been consistently higher since 1994 with a ratio between 1.10 and 1.40.
This pattern raises the question: Is the higher value for the Walgreens P/E relative to both its industry and the market that generally has prevailed since 1992 justified? The microanalyses should provide some insights regarding this question.
Macroanalysis of the Earnings Multiplier
Walgreens Retail Drug
S&P Industrials Index 50.00
45.00 40.00 35.00 30.00 25.00 20.00 15.00 10.00 5.00 0.00
50.00 45.00 40.00 35.00 30.00 25.00 20.00 15.00 10.00 5.00 0.00
Price–Earnings
1999 1997 1995 1993 1991 1989 1987 1985 1983 1981 1979 1977
Year
EXHIBIT 15.12 TIME-SERIES PLOT OF MEAN PRICE–EARNINGS RATIOS FOR WALGREENS, THE RETAIL DRUGSTORE INDUSTRY, AND THE S&P INDUSTRIALS INDEX: 1977–2000
This historical data for the relevant series are contained in Exhibit 15.13.17The relevant question is, Why has the earnings multiplier for Walgreens been generally higher than the market and industry earnings multiplier since 1992? As before, we are looking for estimates of D/E, k, and g to find an earnings multiplier. We will use the historical data in Exhibit 15.13 to determine pat- terns for the data and to develop future projections.
Comparing Dividend-Payout Ratios The dividend-payout ratio for Walgreens typically has been lower than its industry in recent years. The Walgreens-market comparison shows that Walgreens almost always had a lower payout, which by itself would imply a lower P/E ratio for Walgreens than for its industry and the market.
Estimating the Required Rate of Return To find Walgreens’ required rate of return (k), we need to analyze the firm’s fundamental risk characteristics (BR, FR, LR, ERR, and CR) and also derive an estimate based on the SML and a measure of Walgreens’ systematic risk (i.e., its beta).
Walgreens should have relatively low business risk due to its stable sales growth compared to its industry and the aggregate economy. As noted in Chapter 10, for a growth company like Wal- greens it is necessary to adjust for both the growth and size factor by measuring variability around the growth trend and relating this volatility to the mean as in Exhibit 15.14. As shown in the appendix in Chapter 10, after adjusting for size and trend, the results indicated that Walgreens sales and EBIT experienced very stable growth, which indicates lower business risk.
Several financial risk variables for Walgreens, its industry, and the aggregate market are shown in Exhibit 15.15. Notably, these do not consider fairly large leases of stores. The firm’s financial leverage ratio (notably, total assets/equity) has recently been less than 2.00, which is comparable to the industry and definitely lower than the aggregate market. Walgreens has a very large interest coverage ratio, a cash flow/long-term debt ratio of over 300 percent, and a cash flow/total debt ratio of about 30 percent. These financial risk ratios indicate that Walgreens has comparable financial risk to its industry and substantially lower financial risk than the aggregate stock market. In contrast, as shown in Chapter 10, when the leases are considered as they should be, the firm’s financial risk is equal to, or somewhat higher than the market.
The firm’s liquidity risk is quite low compared to its industry and the average firm in the mar- ket. Indicators of market liquidity are (1) the number of stockholders, (2) the number and mar- ket value of shares outstanding, (3) the number of shares traded, and (4) institutional interest in the stock. As of January 1, 2002, Walgreens had 30,000 holders of common stock—a relatively large number. At mid-2002, there were over one billion common shares outstanding (after the 1999 stock split) with a market value of over $35 billion. Clearly, Walgreens would qualify as an investment for institutions that require firms with large market value. Walgreens stock has an annual trading turnover of 55 percent, which is below average. Financial institutions own about 450 million shares of Walgreens, which is about 45 percent of the outstanding shares. Therefore, Walgreens’ large number of stockholders, very large market capitalization, fairly active trading of its stock, and strong institutional interest indicate that Walgreen’s has very little liquidity risk.
As discussed in Chapter 11, the exchange rate risk for companies depends on what propor- tion of sales and earnings are generated outside the United States and the volatility of the exchange rates in the specific countries. Walgreens has very little exchange rate risk or country risk because the firm has virtually no non-U.S. sales.
In summary, Walgreens has below-average business risk, financial risk higher than the market when we consider leases, low liquidity risk, and virtually no exchange rate and country risk. This implies that—based on fundamental factors—the overall risk for Walgreens should be lower than the market.
Microanalysis of the Earnings Multiplier
570 CHAPTER 15 COMPANYANALYSIS ANDSTOCKVALUATION
17Although some prior tables included data through 2001 using estimates for specific ratios, it is not possible to do this for all the variables in Exhibit 15.13 as of mid-2002. These data generally are not available until September.
VARIABLES THAT INFLUENCE THE EARNINGS MULTIPLIER FOR WALGREENS, THE RETAIL DRUGSTORE INDUSTRY, AND THE S&P INDUSTRIALS INDEX: 1977–2001 WALGREENSRETAIL DRUGSTORESS&P INDUSTRIALS YEARD/ENPMTATROATAEROED/ENPMTATROATAEROED/ENPMTATROATAE 197745.801.273.814.842.3911.5620.114.072.8411.561.5317.6843.205.111.276.492.15 197830.312.163.457.452.3417.4423.904.032.8111.321.5217.2141.205.191.276.592.22 197930.332.253.537.942.3018.2727.403.473.0010.411.6517.1836.305.571.307.242.28 198030.472.273.608.172.1617.6529.203.473.0410.551.6617.5140.304.921.316.452.30 198130.422.423.608.712.0818.1231.003.453.0310.451.6517.2541.904.861.286.222.32 198226.932.753.599.872.0620.3431.103.442.9710.221.6616.9654.003.951.174.622.40 198326.332.963.5410.482.0421.3829.303.792.8610.841.8820.3849.604.421.155.082.37 198425.843.113.5210.952.0322.2237.603.042.658.061.9315.5541.504.771.225.822.51 198528.582.983.3910.102.1621.8240.802.962.687.931.8814.9151.503.841.154.422.75 198629.812.823.399.562.1620.6531.903.112.718.431.9416.3556.003.751.074.012.90 198732.082.423.358.112.1917.7531.602.882.808.062.0416.4543.004.711.085.092.97 198828.592.643.408.982.1219.0330.602.902.828.182.0716.9336.905.460.985.353.56 198927.122.873.379.672.0419.7332.292.792.827.872.0315.9744.034.960.974.813.84 199028.192.893.169.132.0218.4531.682.892.828.132.0016.2650.204.170.974.044.01 199129.042.903.219.311.9418.0632.812.912.858.311.8315.2571.812.880.942.723.96 199229.211.953.159.291.9217.8933.592.892.838.191.8214.8966.143.170.963.034.41 199333.522.673.278.731.8416.0846.832.152.796.001.8811.2758.043.630.923.334.81 199429.823.053.179.671.8517.9233.782.892.637.602.0015.1738.945.240.954.984.38 199530.773.093.209.871.8119.1033.672.842.667.562.0315.3639.395.240.975.084.25 199628.953.163.2410.241.7819.4028.813.212.026.482.1714.0637.865.860.935.454.49 199726.973.263.1810.361.7719.8040.951.962.234.372.189.5339.695.610.945.274.77 199824.273.513.1210.951.7219.6024.742.582.045.272.7014.2345.045.080.854.334.75 199920.973.503.0210.571.7017.9124.912.702.095.652.6715.0934.636.190.845.205.10 200018.183.662.9910.941.6818.3519.383.042.928.892.2019.5230.816.310.845.274.99 200116.093.602.7910.031.7017.01NANANANANANANANANANANA Mean28.342.813.329.361.9918.6231.163.062.708.351.9515.8745.504.791.065.043.63
EXHIBIT 15.13 D/E = Dividend payout,equal to dividends/earnings.TAE = Leverage ratio,equal to total assets/equity. NPM = Net profit margin,equal to net income/sales.ROE = Return on equity,equal to net income/equity. TAT = Total asset turnover,equal to sales/total assets.NA = Data not available. ROA = Return on assets. Source:FinancialAnalysts Handbook(New York:Standard & Poor’s,2001). Reprinted with permission.
In addition to the consideration of fundamental factors, one should also consider market- determined risk (beta) based on the CAPM. As noted in connection with the cash flow models, the stock’s beta derived from five years of monthly data relative to the S&P Industrials for the period 1997 to 2001 indicated a beta of 0.90.
These results are consistent with those derived from an analysis of the fundamental factors—
both indicate that Walgreens’ risk is below the aggregate market. This means that the risk pre- mium and the required rate of return (k) for Walgreens stock should be lower than the market.
By itself, this lower k would suggest an earnings multiplier above the market multiplier.
Estimating the Expected Growth Rate Recall that the expected growth rate (g) is deter- mined by the firm’s retention rate and its expected return on equity (ROE). We have already noted Walgreens’ low dividend payout compared to the industry and the aggregate market, which implies a higher retention rate.
As discussed using the DuPont model, a firm’s ROE can be estimated in terms of the three ratios: (1) net profit margin (NPM), (2) total asset turnover (TAT), and (3) the financial leverage multiplier. We also know that NPM ×TAT = Return on Assets (ROA). It is important to examine the relative impact of these two ratios and to compare the ROA of alternative firms as a measure of operating performance—that is, profitability and asset efficiency. Walgreens has experienced a small decline in TAT, but this has been offset by an increase in NPM, causing the firm’s ROA to increase substantially from about 7 percent to over 10 percent, providing an ROA substantially above its industry and the market.
Finally, the firm’s ROE equals the ROA times the financial leverage multiplier (total assets/equity). Notably since 1977 Walgreens has reduced its leverage multiplier from 2.39 to 1.68 while the industry and market have experienced increases (in particular, the market has 572 CHAPTER 15 COMPANYANALYSIS ANDSTOCKVALUATION
12,000.0
2,000.0 22,000.0
17,000.0
7,000.0
x
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Linear Growth Curve Constant Growth Curve Actual Sales
EXHIBIT 15.14 TIME-SERIES PLOT OF WALGREENS SALES USED IN CALCULATION OF SALES VOLATILITY FOR WALGREENS FROM ARITHMETIC MEAN, FROM LINEAR GROWTH CURVE, AND FROM COMPOUND GROWTH CURVE
FINANCIAL RISK RATIOS FOR WALGREENS, THE RETAIL DRUGSTORE INDUSTRY, AND THE S&P INDUSTRIALS: 1977–2000 WALGREENSaRETAIL DRUGSTORESS&P INDUSTRIALS TOTALCASHFLOW/TOTALCASHFLOW/TOTALCASHFLOW/ ASSETS/INTERESTLONG-TERMCASHFLOW/ASSETS/INTERESTLONG-TERMCASHFLOW/ASSETS/INTERESTLONG-TERMCASHFLOW/ YEAREQUITYCOVERAGEDEBTbTOTALDEBTcEQUITYCOVERAGEDEBTTOTALDEBTEQUITYCOVERAGEDEBTTOTALDEBT 19772.396.910.360.131.5328.901.760.412.158.000.630.22 19782.347.930.430.181.5230.901.940.422.227.600.630.22 19792.308.830.500.191.6521.201.210.342.287.700.700.22 19802.169.010.600.201.6620.101.330.352.306.000.660.21 19812.0810.440.910.221.6516.201.740.362.325.000.630.21 19822.0613.381.400.241.6617.402.430.362.404.000.540.18 19832.0419.611.760.261.8820.203.240.352.374.600.610.19 19842.0325.232.140.271.9310.601.430.242.514.100.650.19 19852.1628.651.790.271.8812.100.750.222.754.200.510.16 19862.1617.110.900.231.9412.700.990.242.903.600.510.15 19872.1911.760.940.212.049.400.930.232.974.400.580.17 19882.1211.460.920.202.078.201.000.243.563.800.440.15 19892.0413.941.230.222.037.100.610.233.843.700.430.13 19902.0211.221.670.262.008.200.690.254.013.600.400.12 19911.9418.182.270.281.8310.300.960.273.963.400.340.10 19921.9323.531.650.281.8213.401.130.274.414.000.380.11 19931.8415.592.500.291.8815.800.820.214.814.500.400.10 19941.8510.512.800.232.0016.700.860.234.385.600.500.13 19951.9412.143.150.312.0313.200.790.234.253.400.490.14 19961.9011.403.300.332.1711.990.470.174.494.700.510.15 19971.9111.753.350.332.187.370.490.144.775.630.520.15 19981.7211.301.830.342.7011.850.340.134.755.900.160.10 19991.7011.401.970.342.6713.570.380.145.105.950.200.12 20001.6811.452.170.352.2033.980.850.224.995.100.200.12
EXHIBIT 15.15 aThese ratios do not reflect adjustment for capitalizing operating leases. bLong-term debt does not include deferred taxes. cTotal debt is equal to total assets minus total equity,including preferred stock. Source:Financial Analysts Handbook.(New York:Standard & Poor’s,2001). Reprinted with permission.
increased from 2.08 to 3.50). As a result, the ROEs are similar but the financial risk is different—
that is, Walgreens has a higher ROE but lower financial risk (as noted, with leases the FR is higher than the market).
Using the results for the last three years (1998–2000), the ROEs would be approximately as follows:
The foregoing is meant to highlight the difference among the three units based on history. An analyst would need to estimate future components and derive an expected ROE that reflects the firm’s future performance.
The demonstration can be extended by combining the average annual ROEs derived in the preceding table and the average of recent retention rates from Exhibit 15.16 to derive expected growth rates:
Taken alone, these higher expected growth rates for Walgreens would indicate that it should def- initely have a higher multiple than its industry and the market.
Computing the Earnings Multiplier Comparing our estimates of D/E, k, and g to com- parable values for the industry and the market, we find that Walgreens’ earnings multiplier based on the microanalysis should be greater than the multiplier for its industry and the market. Specif- ically, the dividend-payout ratio points toward a lower multiplier for Walgreens, whereas both the lower risk analysis and the higher expected growth rate would indicate a multiplier for Wal- greens above that of its industry and the market.
The macroanalysis indicated that Walgreens’ multiplier typically has been above its industry and the market, and the microanalysis supported this relationship. Assuming a market multiple of about 23 and a retail drugstore multiplier of about 26, the multiplier for Walgreens should be between 28 and 30, with a tendency toward the upper end of the range and beyond (28–30–32 times). Alternatively, if we inserted some earlier estimated values for D/E, k, and g into the P/E ratio formula, we would not be able to derive an estimated multiplier for Walgreens because g is greater than k. As noted earlier in Chapter 11, because Walgreens is a true growth company, we cannot use the standard DDM formula to estimate a specific multiple. We would need to estimate a value based on the direction of change and the macroanalysis estimates of 28–30–32 times.
Estimate of the Future Value for Walgreens Earlier, we estimated 2002 earnings per share for Walgreens of about $0.97 per share. Assuming multipliers of 28–30–32 implies the fol- lowing estimated future values:
RETENTION EXPECTED
RATE ROE GROWTHRATE
Walgreens 0.79 18.08 0.1428
Retail drugstores 0.77 16.40 0.1148
S&P Industrials 0.63 17.71 0.1116
TOTALASSETS/
NPM TAT ROA EQUITY ROE
Walgreens 3.54 3.04 10.76 1.68 18.08
Retail drugstores 2.77 2.35 6.51 2.52 16.40
S&P Industrials 5.86 0.84 4.92 3.60 17.71
574 CHAPTER 15 COMPANYANALYSIS ANDSTOCKVALUATION
28 ×$0.97 =$27.16 30 ×$0.97 =$29.10 32 ×$0.97 =$31.04
In our prior discussions of valuation, we set forth the investment decision in two forms:
1. Compute the estimated intrinsic value for an investment using your required rate of return as the discount rate. If this intrinsic value is equal to or greater than the current market price of the investment, buy it.
2. Compute the estimated intrinsic value for an investment using your required rate of return as one of the components. Given this intrinsic value, compute the expected rate of return you would receive if you bought the asset at the current market price and assume that this market price migrated to its intrinsic value plus the stocks dividend. If this expected rate of return is equal to or greater than your required rate of return, buy the investment; if the expected return is below your required rate of return, do not buy it.
Making the Investment
Decision
EXPECTED GROWTH RATE COMPONENTS FOR WALGREENS, THE RETAIL DRUGSTORE INDUSTRY, AND THE S&P INDUSTRIALS: 1977–2000
WALGREENS RETAIL DRUGSTORES S&P INDUSTRIALS
RETENTION EXPECTED RETENTION EXPECTED RETENTION EXPECTED
YEAR RATE ROE GROWTHRATE RATE ROE GROWTHRATE RATE ROE GROWTHRATE
1977 0.54 11.56 6.27 0.80 17.68 14.12 0.57 13.95 7.92
1978 0.70 17.44 12.15 0.76 17.21 13.10 0.59 14.63 8.60
1979 0.70 18.27 12.73 0.73 17.18 12.47 0.64 16.51 10.52
1980 0.70 17.65 12.27 0.71 17.51 12.40 0.60 14.82 8.85
1981 0.70 18.12 12.61 0.69 17.25 11.90 0.58 14.43 8.38
1982 0.73 20.34 14.86 0.69 16.96 11.69 0.46 11.09 5.10
1983 0.74 21.38 15.75 0.71 20.38 14.41 0.50 12.05 6.07
1984 0.74 22.22 16.48 0.62 15.55 9.70 0.59 14.61 8.55
1985 0.71 21.82 15.58 0.59 14.91 8.83 0.49 12.14 5.89
1986 0.70 20.65 14.49 0.68 16.35 11.13 0.44 11.64 5.12
1987 0.68 17.75 12.06 0.68 16.45 11.25 0.57 15.11 8.61
1988 0.71 19.03 13.59 0.69 16.93 11.75 0.63 19.06 12.03
1989 0.73 19.73 14.38 0.68 15.97 10.81 0.56 18.46 10.33
1990 0.72 18.45 13.25 0.68 16.26 11.11 0.50 16.22 8.08
1991 0.71 18.06 12.82 0.67 15.25 10.25 0.28 10.77 3.04
1992 0.71 17.89 12.66 0.66 14.89 9.89 0.34 13.37 4.53
1993 0.66 16.08 10.69 0.53 11.27 5.99 0.42 16.02 6.72
1994 0.70 17.92 12.58 0.66 15.17 10.05 0.61 21.79 13.30
1995 0.69 19.10 13.22 0.66 15.36 10.19 0.61 21.62 13.10
1996 0.71 19.40 13.78 0.71 14.06 10.01 0.62 24.49 15.22
1997 0.73 19.80 14.46 0.59 9.53 5.63 0.60 25.14 15.16
1998 0.76 19.60 14.84 0.75 14.23 10.71 0.55 20.59 11.32
1999 0.79 17.91 14.16 0.75 15.09 11.33 0.65 26.51 17.33
2000 0.82 18.35 15.01 0.81 19.52 15.74 0.69 26.33 18.22
Mean 0.71 18.69 13.36 0.69 15.87 11.02 0.55 17.14 9.67
EXHIBIT 15.16
The most obvious comparison is the estimated values derived using the present value of cash flow models and the values estimated using the earnings multiple model to the current market price of Walgreens of about $38 a share. The following is a summary of these estimated values.
Recall that we could not calculate constant-growth models because Walgreens has consistently experienced growth rates above its required rates of return (it is a true growth company).
Because none of the computed values is equal to or larger than the current market price of
$38.00, you would not recommend a purchase of the stock although Walgreens is clearly an out- standing firm. Stated in terms of our earlier discussion, Walgreens is obviously a true growth company, but apparently the firm’s stock is not expected to be a growth stock at its current price.
Comparing Expected Rate of Return to Required Rate of Return In past demon- strations of this decision rule, we have computed an expected rate of return using the intrinsic value and dividend. Although we will again use this technique, we also will introduce another technique for computing an expected rate of return based on the dividend discount model (DDM).
We can compute the expected rate of return, E (Ri), based on our estimated intrinsic value using the formula
➤15.10
where:
IV=the estimated intrinsic value of the stock
BV=the beginning value of the stock (typically its current market price) Div =the expected dividend per share during the holding period
In our case, these values would be
IV=$31.00 (at best) BV=(Assume $38 a share) Div=$0.16
Thus, we know that all the expected returns would be negative. Based on the k of 9.0 percent used in the valuation section, we would not buy this stock because its negative expected rates of return are below our required rate of return (9.0 percent).
The second technique used for deriving an expected rate of return is based on the dividend discount model. You will recall that the DDM states:
E R IV BV Div
i BV
( )= − +
PRESENTVALUE OFCASHFLOWMODELS
Three-stage DDM $23.11
Three-stage FCFE $27.50
Three-stage FCFF (OFCF) $28.90 EARNINGSMULTIPLEMODELS
28 times estimated earnings $27.16 30 times estimated earnings $29.10 32 times estimated earnings $31.04 576 CHAPTER 15 COMPANYANALYSIS ANDSTOCKVALUATION
18Eugene F. Fama and Kenneth R. French, “The Cross Section of Expected Stock Returns,” Journal of Finance 47, no. 2 (June 1992): 427–450; Barr Rosenberg, Kenneth Raid, and Ronald Lanstein, “Persuasive Evidence of Market Ineffi- ciency,” Journal of Portfolio Management 11, no. 3 (Spring 1985): 9–17; and Patricia Fairfield, “P/E, P/B and the Pre- sent Value of Future Dividends,” Financial Analysts Journal 50, no. 4 (July–August 19): 23–31.
➤15.11
Solving to estimate k:
➤15.12
In this equation, k serves as an estimate of the required rate of return when you assume that you know the firm’s future growth rate. Alternatively, an investor can use this equation to esti- mate his or her long-run expected rate of return if you are estimating the future dividend and growth rate. For Walgreens, the P0would be the current price of the stock, D1would be the expected dividend during the investment horizon, and g would be the expected longer-run growth rate, as discussed in connection with Exhibit 15.16.
As an example, assume a current price of $38, an expected dividend of $0.16 per share, and a growth rate of 14 percent, which is the growth rate we used in the earlier microestimate of the multiplier. Notably, it is slightly below the g implied by the recent average values in Exhibit 15.16. This would imply the following estimate of your long-run expected rate of return on Walgreens common stock:
This computation shows that you would expect a long-run rate of return from investing in Wal- greens stock of 14.4 percent. If your required rate of return was 9.0 percent, you would buy this stock recognizing it is a long-run expectation.
ADDITIONAL MEASURES OF RELATIVE VALUE
The best-known measure of relative value for common stock is the price/earnings ratio or the earnings multiplier because it is derived from the dividend growth model and has stood the test of time as a useful measure of relative value. Analysts have also begun to calculate three addi- tional measures of relative value for common stocks—the price/book value ratio, the price/cash flow ratio, and the price/sales ratio, which are demonstrated in this section.
The price-to-book-value ratio (P/BV) has gained prominence because of the studies by several authors.18The rationale is that book value can be a reasonable measure of value for firms that have consistent accounting practice (for example, firms in the same industry). Notably, this mea- sure can apply to firms with negative earnings or negative cash flows. You should not attempt to use this ratio to compare firms with different levels of hard assets—for example, a heavy indus- trial firm to a service firm.
Price/Book Value (P/BV) Ratio
k= +
= +
= =
0 16 38 00 0 140 0 004 0 140
144 14 4 .
. .
. .
. . %
k D
P g
i= 1 +
0
P D
k g
0
= 1
−
The annual P/BV ratios for Walgreens, its industry, and the market are in Exhibit 15.5, along with the ratio of the company P/BV ratio relative to its industry and relative to the market ratio.
In this instance, the major variable that should cause a difference in the P/BV ratio is the firm’s return on investment (ROI) relative to its cost of capital (its WACC). Assuming that most firms in an industry have comparable WACCs, the major differential should be the firm’s ROI because the larger the ROI-WACC difference, the greater the justified P/BV ratio. We will consider this in the subsequent section on EVA.
As shown in Exhibit 15.17, the P/BV ratios for the three components have increased from about 1.5–2.00 to 6.08–8.0. As shown in Exhibit 15.18, which contains a plot of relative valuation ratios, Walgreens has experienced a larger increase in its P/BV ratio than its industry as indicated by its Co/Ind ratio that has gone from about 0.80 to about 1.26. This seems reasonable based upon the difference in ROE for the Co versus the industry. In contrast, the Co/Mkt ratio for Walgreens has declined from about 1.18 to about 0.97 at the end of the period. This latter trend is interesting because the ROE for Walgreens has consistently been greater than for the S&P Industrials until 1995 when the ROE for the S&P Industrials rose substantially. One must question whether this declining trend in the Co/Mkt ratio is because the beginning relationship was too high.
As noted in Chapter 10, the price/cash flow ratio has grown in prominence and use because many observers contend that a firm’s cash flow is less subject to manipulation than its earnings per share and because cash flows are widely used in the present value of cash flow models discussed earlier. An important question is, which of the several cash flow specifications should an analyst employ? In this analysis, we use the EBITDA cash flow measure equal to net income plus inter- est, depreciation, and taxes because this cash flow measure can be derived for both the RDS industry and the market. Although it is certainly legitimate to have a preference for one of the other cash flow measures discussed, a demonstration using this measure should provide a valid comparison for learning purposes.
Price/Cash Flow (P/CF) Ratio
578 CHAPTER 15 COMPANYANALYSIS ANDSTOCKVALUATION
10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00
10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00
Price–Book Value Ratio
Walgreens Retail Drug S&P Industrials
Year
1999 1997 1995 1993 1991 1989 1987 1985 1983 1981 1979 1977
EXHIBIT 15.17 TIME-SERIES PLOT OF MEAN PRICE–BOOK VALUE RATIOS FOR WALGREENS, THE RETAIL DRUGSTORE INDUSTRY, AND S&P INDUSTRIALS: 1977–2000