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How is the PE ratio related to growth?

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Investing - Investing Articles

Written by Hugh McManus

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Are the PE ratio and Growth connected?  People often observe some kind of connection between the PE ratio and the growth rate in earnings of a company.   Through the PEG ratio, Peter Lynch popularized the connection in the book “One Up on Wall Street.”  In fact, Peter Lynch suggests a direct correlation: a PE ratio of 15, say, implies a future annual earnings per share (EPS) growth rate of 15%.  There are many ways to think about how such connection happens; here’s one. As a conservative investor, we’re interested in earnings—both their quality and sustainability.  One assumption behind the SSG is that earnings drive stock price appreciation.  It has been observed that a company with steadily growing earnings is rewarded with a concomitant growth in its stock price.  If earnings falter for some reason, so too will the rise in the value of a share in that company.  The PE ratio is simply the price of a share in the company divided by its annual EPS.   The PE links the share price with the EPS.   In a sense, the PE can be viewed as the price an investor is willing to pay to “own” each dollar of those earnings.  You could view it as a PE of 15 implies that, on average, the investor is wiling to pay $15 for each $1 of earnings generated by the company.  As investors, we are also forward looking.  While a good, steady earnings history is important to NAIC investors, so too are excellent prospects for the future.  In fact, one other assumption underlying the SSG is that, all else being equal, the future will mirror the past.  It may not be perfect and it certainly won’t be a carbon copy, but the past has proven to be a pretty good guide for what to expect in the next year or so.As mentioned earlier, the PE ratio is nothing more than the price of a share divided by its earnings per share.  Let’s say that two companies are equal in all respects except that one has a past (and projected) growth rate higher than the other.  Let’s say one (Firm A)  grows at 10% annually, whereas the other (Firm B) grows at a more impressive rate of 20%.  Let’s say that today, the financials of both firms are essentially identical.  The only difference is the past and projected growth rates.  What would a rational investor do?Well, if all earnings were paid out as dividends, then you’d expect the faster growing company to be worth more—you’re going to get much more in dividend payments in the future.  For example, if today each has a dividend of $1/share, firm A will have a $1.10 dividend in 2006, while firm B will reward shareholders with $1.20.   (Remember all earnings are paid out).  Most rational investors will value firm B more highly because there’s a greater future flow of cash when compared to firm A.So, what if none of those earnings is paid out as dividends?  What if all earnings are retained by the company and find their way into shareholders’ equity?  Why should a faster growing company have a higher PE ratio?Give this conundrum some thought before turning to the discussion on the final page.  In the time honored tradition of mathematical proofs, one way to think about the problem is to start of assuming that the PE’s should be the same and see where that takes you! You could argue that it shouldn’t make any difference whether the earnings are retained or not.  If the earnings are paid out as dividends, the higher growth company will be viewed as more valuable, even if the dividends happen to be identical today.  The fact that earnings are retained should not really make a difference.If we proceed with the assumption that both companies are identical, except that Firm A has an EPS growth rate of 10%, while Firm B grows at twice that rate.   We start of by claiming that the PE ratio should be the same for each company; accepting the assumption leads to some interesting conclusions.   Other things in the company financials soon start to go out of whack. Over time, the financial statements for each company start to look very different.  The faster growing company increases its assets and particularly its shareholders’ equity at a greater rate.  If the firms are otherwise equal, the faster growing firm should also amass a greater amount of cash over time too.  In fact, valuations start to look strange.  With a constant PE ratio, the faster growing firm starts to look like a better ‘deal’ than its slower growth counterpart.  It’s not surprising then that the market tends to place a greater value on many faster growing firms.  This greater value being reflected in a higher price/earnings ratio for the firm.  People seem ready to pay a relatively higher price for a faster growing company. < Prev   Next >