If a firm’s return on equity (ROE) is greater than the rate of return demanded by investors ®, which of the following statements is CORRECT? There is: A) a high franchise P/E value. B) negative franchise value. C) potential franchise value. Your answer: A was incorrect. The correct answer was C) potential franchise value. If ROE is greater than r, then there is some benefit in reinvesting the earnings within the firm, therefore, there is potential franchise value. — question on this: why is A not the correct answer? Intrinsic PE = tangible PE + franchise PE. is their rationale that since franchise PE = franchse factor x growth factor, having a higher ROE than r will raise your franchise factor but not necsarrily your franchise PE because growth (and thus the growth factor) may be very low? i never even saw the term “potential franchise value” in the schweser books, what is the definition of that?
You say High , I say Low , we both say potential
Well you are not sure whether the franchise factor will be high or low, I mean what can you define as high? So C looks to be a good answer
The franchise factor will be high. Franchise factor = 1/r - 1/ROE If a firm’s return on equity (ROE) is greater than the rate of return demanded by investors ®, then a high ROE makes 1/ROE low, making (1/r - 1/ROE) high.
“High” is relative . “High” or “Low” is a matter of scale perception. For example “Low” is also a “potential” gain , although it is “lower” than “High” . I cannot compare “High” to anything given in the question , so I just say “potential” which is neutral to both “high” and “low”
ok so in other words, you know franchise P/E will be highER due to the highER ROE, but cannot in the technical sense say it is HIGH because after all what is high. so potential franchise value just says it could potentially be high due to the highER ROE. and i guess if choice A said “higher franchise P/Evalue” then that could be a correct answer. aam i reading all that right?
yes that’s right . You could even say that it has “potential franchise value” instead of saying it has “high potential value” . That’s what the question says : “potential franchise value”
Just to beat a dead horse here, I thought I’d elaborate: if you plug in values for ROE and r you could say that if r = 9.9% and ROE = 10%then your franchise PE = (1/.099) - (1/.10) = 10.10 - 10 or .10 So basically even though ROE > r, your franchise PE is only adding 10cents to your current price (which I would consider small, but that’s just my opinion).
by that same logic, ‘potential’ doesn’t mean ‘certain’. But it is in fact certain that the franchise value will be some positive number, no matter how big or small. So C isn’t any better.