by Martin Chapman

Created on: June 25, 2008   Last Updated: February 23, 2012

Why does anybody want to write about a Price to Earnings Ratio?

Why? ... simply because the PE Ratio is the most important of all stock valuation tools. It is not only popular but if properly used can be extremely effective as well. Essentially the PE Ratio calculates the "Payback Period" of an investment. This article looks at the effect of Growth on the PE and discusses the limitations of its use.

INTRODUCTION

The Price/Earnings Ratio ("PE") is used by investors to assess how many years it will take them to get the value of their investment back. Assuming that the earnings of the company are not growing and that the earnings are positive, then the PE Ratio of the stock will equate to the "payback period" on the investment.

The PE is not just for publicly quoted shares, but is also used in the purchase or sale of privately held companies, where exit multiples are calculated using the value paid and net profits, which may in be at a discount to the Public PE multiples for companies in the same sector due to the lack of liquidity for the investor.

GROWTH STOCKS AND THE PE RATIO

A business can theoretically be valued using the present value of all future dividends. The Dividend Discount Model ("DDM") is a conservative model that attributes a value to a company based on its discounted future dividends.

The basic valuation model is called the Gordon's Growth Model and it is calculated as follows:
Value of Stock = D1/(r-g), where D1 = the dividend next year, r = the required rate of return for the equity investor, g = the growth rate of dividends in perpetuity.

The DDM is a simple model, which works quite well, when the dividends are growing at a "stable rate". The difficultly is to find an appropriate and "stable rate" of growth for the future. In theory a firm cannot grow at a faster rate than the economy forever, so it can be assumed that a firm with a stable growth rate is one whose growth rate does not exceed expected inflation plus the expected real growth rate of the economy.

If both sides of the DDM equation are divided by the earnings per share ("E"), then the formula becomes: (Value of Stock)/E= (D1/E)/(r-g), or in other words: P/E = the payout ratio/(r-g)

Similar to the Gordon Growth Model, this PE formula is extreme sensitivity to the growth rate used. Furthermore, it does not effectively reflect the various stages of growth through which businesses go. For this purpose Multi-Phase DDM models were developed, which are not discussed in this article.

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