Summary- P/E can be decomposed into 2 factors: (1) the Franchise Factor represents the P/E impact of new investments at and (2) a growth measure that reflects the magnitude of these new investment opportunities.- Growth alone cannot impact to P/E- Experiment 4 firmsFirm A: - ROE = market capitalization rate (12%)- retain 2/3 earning, pay out the restFirm B:- ROE = ROE firm A- Pay out all earningFirm C:- ROE = 15%- Pay out all earningFirm D:- ROE = 15%- retain 2/3 earning, pay out the rest=> firm D can be viewed as a combination of (1) full payout equivalent firm and (2) a stream of opportunities or investment at 3 percent above the market ratePremium of firm D- Firm D has opportunities to invest a fraction of its earnings at 15% (larger than the base rate of 12%)- P/E of firm D (16.67) is higher than base P/E (8.33)- Market stock price of firm D is 250, 125 comes from the PV of all excess earnings in the future, the other half comes from full payout equivalent to firm C (recall firm C in previous part)- The source of the premium (excess P/E) is that new investment of firm D yields an excess return of 3% over market rate. This is the real value added to investors. Also because of this added value, investors are willing to pay up for the stock (250 compare with 100 or 125 of A, B and C)Franchise Opportunities, Growth Equivalent- A firm's opportunities to earn excess of the equilibrium market rate can be thought of as franchise growth opportunities.- The firm is assumed to fully utilize franchise opportunities.- The stream of all future franchise growth opportunities can be summed up into 1 single number G, called Growth Equivalent of these investment.- G is computed by discounting all future franchise growth opportunities at the market rate and divided by the book value of the firm. The result will be percentage.- Instead of serial investments over years (include retaining, investing, earning grows and repeat it), we can invest the amount of G at once. This investment will yield the earnings for perpetuity. The PV of this stream of earnings equals to the PV of the stream of earning of serial investment.Franchise FactorThe FF is the increase in P/E that results from 1 unit of PV Growth EquivalentFF = (r k)/rkr: firm's ROEk: market rate=> P/E = Base P/E + FF*G- As ROE increases, FF approach the inverse of the market rate. In other words, 100% percent increase in book value can never increase P/E by more than base P/EConclusion- Growth alone cannot impact to P/E. It needs to be combined with above-market ROE- FF is actually derived from the above-market ROE- The simple model for higher P/EP/E = Base P/E + FF*GBase P/E can be attained by using setting similar to firms A, B or C.