CHAPTER 20

REVENUE MULTIPLES AND SECTOR-SPECIFIC MULTIPLES

Problem 1
A.
Dividend Payout Ratio = $1.12/$2.45 = 0.4571
Expected Growth Rate = 6%
Cost of Equity = 7% + 0.9 (5.5%) = 11.95%
Profit Margin = 2.45/122 = 2%
P/S Ratio = .02 * 0.4571 * (1.06)/(.1195 - .06) = 0.16288
Price Based on this Multiple = 0.16288 * 122 = $19.87
B.

P/S Ratio Needed for a Price of $34 = $34/122 = 0.2787

Profit Margin Needed for this P/S Ratio
= 0.2787 * (.1195 - .06)/(0.4571 * 1.06)
= 0.0342 or 3.42%

Problem 2
A. These are the two companies with high expected growth rates. These high growth rates
may explain the high P/S ratios. In addition, the Bombay company has the highest profit
margin of the group.
B.
Correlation between P/S ratio and profit margin =
Correlation between P/S ratio and expected growth =
Correlation between P/S ratio and beta =
Correlation between P/S ratio and payout =

0.8840
0.7694
0.2754
-0.4390

C. One measure that might work is the ratio of Price/Sales (P/S) ratio to profit margin. On
this basis, Bradlee's which has a P/S ratio of 0.09 and a profit margin of 1.04%, Caldor
and Sears are most likely to be undervalued, whereas the Bombay company with P/SMargin ratio of 0.56 is most likely to be overvalued.
Company
Price Sales P/S Profit Exp.
Beta P/SRatio Margin Growth
Margin
Bombay Co.
$38 $9.70 3.92 7.01% 29.00% 1.45 0.559
Bradlees
15 168.6 0.09 1.04% 12.00% 1.15 0.086
Caldor
32 147.45 0.22 1.83% 12.50% 1.55 0.119

Consol. Store
21
23
0.91 4.13% 26.50% 1.35 0.221
Dayton Hudson 73 272.9 0.27 1.70% 12.50% 1.3 0.157
Federated
22
58.9 0.37 2.38% 10.00% 1.45 0.157
Kmart
23 101.45 0.23 1.72% 11.50% 1.3 0.131
Nordstrom
36 43.85 0.82 3.65% 11.50% 1.45 0.225
Penney
54 81.05 0.67 4.32% 10.50% 1.1 0.154
Sears
57
150 0.38 3.03% 11.00% 1.35 0.125
Tiffany's
32 35.65 0.9 4.21% 10.50% 1.5 0.213
Wal-Mart
30 29.35 1.02 3.58% 18.50% 1.3 0.286
Woolworth
23 74.15 0.31 1.82% 13.00% 1.25 0.17
Alternatively, a regression of P/S ratios against the fundamental variables could have been
run and estimated P/S ratios can be obtained.
Problem 3
A.
Profit Margin = 221/8298 = 2.66%

(1.135)5
0.31*(1.135)* 1

0.60*(1.135)5 *(1.06)
(1.13325)
PS =0.0266*
+

(.13325 - .135)
(.13325-.06) (1.13325)5

= 0.275

B. P/S ratio for Stable Growth Firm with Same Margin

= 0.0266 * 0.6 * 1.06/(.13325 - .06) = 0.231
P/S ratio attributable to High Growth = 0.275 - 0.231 = 0.044
Problem 4

(1.11)5
0.45 * (1.11) * 1

(1.125)
0.60 * (1.11)5 *(1.06)
PS =0.1784*
+

A.
(.125 - .11)
(.125-.06) (1.125)5

= 2.02

B. New Margin = 100/700 = 14.29%

Old Growth Rate
= Old Profit Margin * Sales/Book Value * (1 - Payout ratio)
= .1784 * Sales/Book Value * (1 - 0.45) = 11%
Sales/Book Value = 1.12

New Growth Rate (for high growth period)

= .1429 * 1.12 * (1 - 0.45) = 8.81%
Price / Sales Ratio

(1.0881)5
0.45 * (1.0881) * 1
5
5

(1.125)
0.60 * (1.0881) *(1.06)
= 0.1429*
+
(.125 - .0881)
(.125-.06) (1.125)5

= 1.47
Problem 5
A.
Payout Ratio
Sales/Book Value
Expected Growth Rate
Cost of Equity
Profit Margin
P/S Ratio =
Price per share =

Next 10 Years After Year 10

33.00%
60.00%
2.50
2.50
16.75%
6.00%
14.15%
12.50%
10.00%
10.00%
1.59991143
$39.00

B.
Payout Ratio
Sales/Book Value
Expected Growth Rate
Cost of Equity
Profit Margin

Next 10 Years After Year 10

33.00%
60.00%
3.00
3.00
16.08%
6.00%
14.15%
12.50%
8.00%
8.00%

P/S Ratio =
1.21549194
Price Per Share =
$35.55
C. The status quo strategy is best, since it leads to a higher price per share.
D. Sales would have to drop 20%. (Sales/book value ratio would have to be 2.40 for the
two strategies to be equivalent.)

Problem 6
A. The coefficients on this regression measure both the direction and the magnitude of the
relationship between P/S ratios and independent variables. My concerns would be the same
as for the peer group regression.
B.
Company

P/S
Profit Payout Exp. Beta Predicte
Ratio Margin
Growth
d
P/S
Arbor Drugs
0.42 3.40% 18% 14.00% 1.05 0.39904
Big B Inc.
0.30 1.90% 14% 23.50% 0.70 0.48704
Drug Emporium
0.10 0.60%
0% 27.50% 0.90 0.28121
Fay's Inc.
0.15 1.30% 37% 11.50% 0.90 0.34188
Genovese
0.18 1.70% 26% 10.50% 0.80 0.37292
Longs Drug
0.30 2.00% 46% 6.00% 0.90 0.38680
Perry Drugs
0.12 1.30%
0% 12.50% 1.10 0.14108
Rite Aid
0.33 3.20% 37% 10.50% 0.90 0.48487
Walgreen
0.60 2.70% 31% 13.50% 1.15 0.33992
These predictions use the information in the entire cross-section, and should be more
reliable.
C. P/S = 0.42 + 0.33 * 0 + 0.73 * 0.20 - 0.43 * 0.93 + 7.91 * 0.06
= 0.64
The values in this regression are the values of the private firm being valued.
Market Value of Equity
= Revenues * Price/Sales Ratio
= 250 * 0.64 = $160 million
Problem 7
a. After-tax operating margin = 1.5/15 = 10%
Return on capital = After-tax Operating Margin * Turnover ratio = 10%*1.5 = 15%
Reinvestment rate = 5%/15% = 33.33%
Value to sales ratio = After-tax Margin * (1- Reinvestment rate) (1+g)/ (Cost of capital g)
= .10 (1-.3333) (1.05)/(.10-.05) = 1.40
b. Reinvestment rate in first 5 years = g/ ROC = 10/15 = 66.67%

Value/Sales Ratio
5

(1-.6667) * (1.10) * 1 (1.10)5

(1.10) (1-.3333) * (1.10) 5 *(1.05)

=0.10*
+

(.10 - .10)
(.10-.05) (1.10)5

(1-.3333) * (1.10) *(1.05)

= 0.10* (1-.6667) * 5+
= 1.57

(.10-.05) (1.10)5
Problem 8
Value to sales ratio for Estee Lauder = 0.45 + 8.5 (.16) = 1.81
Value to sales ratio for GenCosmetics = 0.45 + 8.5 (.05) = 0.875
Value of brand name = (1.81 0.875) (500) = $467.5 million
Problem 9
a. Return on capital = Operating Margin * Sales/ Book
=(18/ 100)*(100/90) = 20%
Reinvestment rate = g/ ROC = 5/20 = 25%
Value to Sales ratio = .18 (1-.25)(1.05)/(.10-.05) = 2.835
b. Return on capital for generic firms = 10%
Reinvestment rate = 5/10 = 50%
Value to Sales ratio = .09 (1-.5)(1.05)/(.10-.05) = 0.945
Brand name value = (2.835 0.945) (100) = $ 189 million