O'Reilly logo

Equity Valuation and Portfolio Management by Harry M. Markowitz, Frank J. Fabozzi

Stay ahead with the world's most comprehensive technology and business learning platform.

With Safari, you learn the way you learn best. Get unlimited access to videos, live online training, learning paths, books, tutorials, and more.

Start Free Trial

No credit card required

THE LINK BETWEEN EARNINGS AND RETURNS

The P/E multiple that investors put on current earnings when valuing them, as well as other commonly used valuation metrics, shift significantly over time. Exhibit 5.1 shows the U.S. trailing P/E multiple since 1871. As can be seen, there is both a cyclical component to the changes in the multiple as well as movements at lower frequencies. The P/E multiple stayed below long term averages for most of the 1970s and above for a big part of the 1990s.

There are many potential reasons for these movements in the P/E ratio. One way to think about these drivers is to use a simple dividend discount model (DDM) with constant growth rates to measure the fair value of the market. In such a model, we have that

image

where P is the theoretical market price, E0 is the level of earnings over the last year, E1 is the level of earnings over the next year, PO is the payout ratio, Rf is the nominal risk-free interest rate, ERP is the equity risk premium, and G is the nominal growth rate.

Dividing through by E gives

image

EXHIBIT 5.1 The P/E Multiple has both Cyclical and Lower Frequency Movements

image

Therefore, changes in the P/E multiple over time could arise from changes in payout ...

With Safari, you learn the way you learn best. Get unlimited access to videos, live online training, learning paths, books, interactive tutorials, and more.

Start Free Trial

No credit card required