Using the Price-to-Earnings Harmonic Mean to Improve Firm Valuation Estimates

Abstract

This paper reviews some well-known options to estimate the portfolio average of the price-earnings (P/E) multiple, emphasizing the logic and calculation of the harmonic mean. The harmonic mean is a useful but oftentimes unfamiliar calculation to many students and professionals. The simple arithmetic mean when applied to non-price normalized ratios such as the P/E is biased upwards and cannot be numerically justified, since it is based on equalized earnings. The paper advocates the use of the classic harmonic mean when the need is for an equal-dollar-weighted average and the weighted-average harmonic mean when the need is for an index style market-weighted average.

Keywords: P/E ratio, P/E multiple, portfolio PE, portfolio P/E, harmonic mean versus arithmetic mean versus geometric mean

JEL Classification: G