CHAPTER A PP LI CATI O N Stocks, Rational Expectations, and the Efficient Market Hypothesis 145 Stock Valuation, PE Ratio Approach The average industry PE ratio for restaurants similar to Applebee s, a pub restaurant chain, is 23 What is the current price of Applebee s if earnings per share are projected to be $1.13? Solution Using Equation and the data given we find: P0 P0 P/E E 23 $1.13 $25.99 The PE ratio approach is especially useful for valuing privately held firms and firms that not pay dividends The weakness of the PE approach to valuation is that by using an industry average PE ratio, firm-specific factors that might contribute to a long-term PE ratio above or below the average are ignored in the analysis A skilled analyst will adjust the PE ratio up or down to reflect unique characteristics of a firm when estimating its stock price HOW T HE MARKE T SE T S STOCK P RI CES Suppose you went to an auto auction The cars are available for inspection before the auction begins, and you find a little Mazda Miata that you like You test-drive it in the parking lot and notice that it makes a few strange noises, but you decide that you would still like the car You decide $5000 would be a fair price that would allow you to pay some repair bills should the noises turn out to be serious You see that the auction is ready to begin, so you go in and wait for the Miata to enter Suppose there is another buyer who also spots the Miata He test-drives the car and recognizes that the noises are simply the result of worn brake pads that he can fix himself at a nominal cost He decides that the car is worth $7000 He also goes in and waits for the Miata to enter Who will buy the car and for how much? Suppose only the two of you are interested in the Miata You begin the bidding at $4000 He ups your bid to $4500 You bid your top price of $5000 He counters with $5100 The price is now higher than you are willing to pay, so you stop bidding The car is sold to the moreinformed buyer for $5100 This simple example raises a number of points First, the price is set by the buyer willing to pay the highest price The price is not necessarily the highest price the asset could fetch, but it is incrementally greater than what any other buyer is willing to pay Second, the market price will be set by the buyer who can take best advantage of the asset The buyer who purchased the car knew that he could fix the noise easily and cheaply Because of this he was willing to pay more for the car than you were The same concept holds for other assets For example, a piece of property or a building will sell to the buyer who can put the asset to the most productive use Finally, the example shows the role played by information in asset pricing Superior information about an asset can increase its value by reducing its risk When you consider buying a stock, there are many unknowns about the future cash flows The buyer who has the best information about these cash flows will discount them at a lower interest rate than will a buyer who is very uncertain