Franchise Price/Earnings Ratio Calculation | CFA® Level 1 Test Prep

Franchise Price/Earnings Ratio Calculation

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Question

A portfolio manager with Churn Brothers Brokerage is examining shares of a large industrial firm and has gathered the following information:

Market discount rate: 13.75% per year

Observed Price/Earnings ratio: 15.43

Given this information, what is the Franchise Price/Earnings ratio for this large industrial firm?

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Explanations

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A. B. C. D. E.

B

The Franchise Factor method of value measurement is in many respects similar to EVA and MVA calculations. When examining a company using the franchise value approach, the observed price-to-earnings ratio is broken down into its two components - (1) the "base P/E," which is based on the Company's ongoing performance, and (2) a "franchise P/E" that is based on the expected value of new and profitable business opportunities. This relationship is illustrated as follows:

Franchise P/E = Observed P/E - Base P/E

where the Base P/E equals the reciprocal of the market discount rate. For example, if the market discount rate is 13.75%, the base P/E would be equal to 7.27273

In this example, all the necessary information has been provided, and the calculation of the Franchise P/E is as follows:

Franchise P/E = (15.43 - 7.27273) = 8.15727

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