Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

OVERPRICING OF HIGH-P/E STOCKS

The poor returns from high-P/E stocks could be caused in part by the failure of high-P/E firms to meet growth expectations. Fama and French (1992) and Jaffe, Keim, and Westerfield (1989), among others, reported a negative relationship between stock market returns and P/Es (or, more precisely, a positive relationship between returns and earnings-to-price ratios).4 Recent evidence suggests that the earnings of high-P/E firms may not grow at a rate fast enough to justify their current prices. Lakonishok, Shleifer, and Vishny (1994) and Fuller, Huberts, and Levinson (1993) found that firms with high P/Es do have higher future earnings growth rates than low-P/E firms but that superior growth tends to last for a fairly short period of time—eight years or less.

Is eight years of superior earnings growth long enough to justify a high P/E? Fuller, Huberts, and Levinson concluded that the superior earnings growth of high-P/E stocks is consistent with the correct pricing of stocks across P/E groups. Haugen (1994) looked at the same data and concluded that high-P/E stocks may be systematically overpriced. Without an objective benchmark, this conflict cannot be resolved. The model presented here is a first step toward identifying such a benchmark.