Question

Q-4 (20 points) Definition of Valuation Ratios. In early 2018, Abercrombie & Fitch (ANF) and Gap (GPS) had the following financial information (in $ million): ANF GPS Market capitalization 1,538 12,347 Debt 250 1,249 Cash 676 1,783 Revenue 3,493 15,855 Net Income 11 848 If you only have access to the above information: (a) To assess the market value of the firm's underlying business, which valuation ratio is calculated based on the firm's market capitalization? Calculate that valuation ratio for Abercrombie & Fitch (ANF) and Gap (GPS). (b) To assess the market value of the firm's underlying business, which valuation ratio is calcu- lated based on the firm's enterprise value? Calculate that valuation ratio for Abercrombie & Fitch (ANF) and Gap (GPS). (c) Briefly explain the rationale behind the difference in denominators between the two valu- ation ratios you used in (a) and (b).

Answer 1

A. Valuation ratio based on market capitalisation is P/E OR Market Cap/Net Income arranged as   (Share Price*Number of shares)/(Earning per share*Number of Shares)

ANF PE ratio = 1538/11 = 139.81

GPS PE Ratio= 12347/848 = 14.56

B. Valuation ratio based on firm's underlying business is : EV/Revenue.

We use formula of EV= market capitalisation + Debt- Cash

ANF EV = 1538+250-676 =1112

ANF EV/Revenue ratio= 1112/3493=  0.32

GPS EV = 12347+ 1249-1783=11813

GPS EV/Revenue =11813/15855= 0.75

C.  The difference between choice of denominators is that PE or market cap to net income ratio deal with only equity. Net income is derived after adjusting for interest expense and is bottom line of the statement. Net income in general is what equity holders receive making the ratio consistent.

While EV takes into account entire firm value i.e. market cap + debt. That means it doesn't differentiate between debt and equity holders. Therefore we use Revenue because it's earned at firm level and ignores capital structure.