Business Risk and the Earnings Multiplier

Abstract

THE EXCELLENT SUMMARY of currently popular common stock valuation methods which recently appeared in the Journal' draws attention to their almost exclusive emphasis on growth prospects in assessing the firm's expectations and in translating these expectations into a present value for its stock. This emphasis, of course, has the effect of de-emphasizing the bearing of other considerations upon the basic discount rate. Four of the methods (Clendenin, Bauman, Jenks, Kurtz) allude to a somewhat vague and subjective quality adjustment, but in general most common stock valuation methods give little or no weight to factors other than expected growth rate and duration in deriving the earnings capitalization rate or its reciprocal, the earnings multiplier. An important exception is that of Molodovsky who explicitly asserts that the nature of the industry and the firm's particular characteristics should determine the length of the earnings projection and the selection of the basic discount rate. This article reports the results of empirical studies which lend support to Molodovsky's position by suggesting that at least one consideration other than growth prospects may have significant bearin, on the basic discount rate. In theory, the nature of the discount rate is clear enough. It is the sum of (a) the rate of pure interest, i.e., the rate of return on a riskless investment, and (b) a premium sufficient to compensate for the investment risk, the chance that expectations will not be fulfilled.2 The investment risk consists of (i) business risk, attributable to production and marketing conditions in the firm regardless of the manner in which its resources are financed, and (ii) financial risk, attributable to the manner in which the firm's resources are financed, i.e., to the degree of leverage in the capital structure. Business risk is the chance that capital productivity expectations will not be fulfilled. Financial risk is the chance that leverage profit expectations will not be fulfilled. Capital productivity, leverage profit, and book value per share are the sole determinants of earnings per share.' Since capital productivity and leverage profit typically show little tendency toward persistent change, expectations of growth in earnings per share are mainly determined by expectations of growth in book value per share. Finally, the more distant the expectation of growth (or of capital productivity or of leverage profit, for that matter) the greater the chance that the expectation will not be fulfilled. It seems altogether appropriate that careful and systematic assessment of growth prospects should be the major consideration in common stock valuation, especially in those cases where current market prices obviously reflect expectations markedly higher than current performance. But it is not clear that other considerations should be so nearly excluded as they currently are. Recent statistical studies have yielded evidence that industrial differences of business risk4 may be quite significant. These studies measure the capital productivity of companies in four industries having markedly different production and marketing characteristics. The samples consist of all (97) of the mining companies, all (103) of the food processors, half (99) of the machinery manufacturers, and threefourths (98) of the retail stores whose financial statements for the seven years 1957 through 1963 were published in Moody's Manuals.) Each firm's capital productivity was computed by dividing its net income after depreciation, depletion and taxes, but before interest, by its total tangible assets net of depreciation and depletion. In order to determine their predictive value these productivity figures were subjected to variance analysis.' For the mining companies the mean productivity of all 97 firms for all seven years was 5.2%. The variance between the individual firm means was .01301, the variance among years was .00106, and the resulting F ratio was 12.294 with 96 and 502 degrees of freedom. For the food processors the mean productivity was 6.7%, the interfirm variance .00891, the interyear variance .00058, and the F ratio 15.220 with 102 and 618 degrees of freedom. For the machinery manufacturers the mean productivity was 5.4%, the interfirm variance .00985, the interyear variance .00147, and the F ratio 6.690 with 98 and 594 degrees of freedom. For the retail stores the mean productivity was 4.8%, the interfirm variance .00535, the interyear variance .00061, and the F ratio 8.664 with 97 and 588 degrees of freedom. These results indicate that the predictive value of the data for all four groups is highly significant. Figures 1 through 4 represent cumulative frequency distributions of the individual firm means. On the axes are indicated the upper limits of the intervals; so it is convenient to read off, from the vertical axis of each Robert W. Mayer is Pro.fessor of Finance in the University of Illinois. The empirical studies which form the basis for this article are being conducted under a grant from the Research Board of the Graduate College in the University.