Question

Richmond Rent-A-Car is about to go public. The investment banking firm of Tinkers, Evers & Chance is attempting to price the issue. The car rental industry generally trades at a 20 percent discount below the P/E ratio on the Standard & Poor’s 500 Stock Index. Assume that index currently has a P/E ratio of 25. The firm can be compared to the car rental industry as follows:

	Richmond	Car Rental Industry
Growth rate in earnings per share.....	15%	10%
Consistency of performance.............	Increased earnings 4 out of 5 years	Increased earnings 3 out of 5 years
Debt to total assets.....................	52%	39%
Turnover of product.........................	Slightly below average	Average
Quality of management..................	High	Average

Assume, in assessing the initial P/E ratio, the investment banker will first determine the appropriate industry P/E based on the Standard & Poor’s 500 Index. Then a half point will be added to the P/E ratio for each case in which Richmond Rent-A-Car is superior to the industry norm, and a half point will be deducted for an inferior comparison. On this basis, what should the initial P/E be for the firm?

Short answer

The initial P/E ratio of the company will be 22.5.

Step-by-step solution

Computation of discounted P/E ratio

$\begin{array}{rcl}\mathrm{Discounted}\mathrm{P}/\mathrm{E}\mathrm{Ratio}& =& \left(1-\mathrm{Industry}\mathrm{discount}\mathrm{rate}\right)\times \mathrm{Index}\text{'}\mathrm{s}\mathrm{P}/\mathrm{E}\mathrm{ratio}\\ & =& \left(1-20\%\right)\times 25\\ & =& \left(0.8\right)\times 25\\ & =& 20\end{array}$

Computation of the points required to be added in the discounted P/E ratio

As the stock index of the company is 500, then it means that for each superior outcome as compared to the industry norm, 0.5 will be added, and the same will be deducted in the case of inferiority.

Hence, the total points required to be added are as follows:

Particulars	Points
Earnings per share growth rate (Superior)	0.5
Performance consistency (Superior)	0.5
Debt to total asset ratio (Superior)	0.5
Product turnover (Superior)	0.5
Management’s quality (Superior)	0.5
Total	2.5

Computation on initial P/E ratio

$\begin{array}{rcl}\mathrm{Initial}\mathrm{P}/\mathrm{E}\mathrm{ratio}& =& \mathrm{Discounted}\mathrm{P}/\mathrm{E}\mathrm{ratio}+\mathrm{Additional}\mathrm{points}\\ & =& 20+2.5\\ & =& 22.5\end{array}$