On the Interpretation of P/E-Ratios in Relation to Growth
19 Pages Posted: 15 Mar 2022
Date Written: March 1, 2022
Abstract
We analyze the necessary conditions for a positive relation between the price-earnings ratio (P/E) and expected growth, which is often claimed in financial practice, using the simple Gordon equity valuation model. The conditions are entirely based on observable valuation ratios, specifically the dividend-price (D/P) and price-to-book (P/B) ratios, respectively, the fundamentals implied by the Gordon model. A positive relationship between P/E and expected growth requires a minimum volatility (or cross-sectional variability) of P/B and D/P. While this conclusion gets, at best, some empirical support in cross-sectional comparisons of stock valuations, it fails to be adequate for temporal variations of P/E-ratios.
Keywords: Stock market valuation, price-earnings ratio, growth, valuation multiples, Gordon model
JEL Classification: G12, G32, E44
Suggested Citation: Suggested Citation