The Price/Earnings Ratio, Growth, and Interest Rates: The Smartest BET

Abstract

The price/earnings ratio (PE) is the most ubiquitous measure of investment value. It appears to tell us how many years would be required for accumulated earnings to equal today’s price (the break-even time [BET]), but that interpretation is built on unrealistic assumptions about a company’s future: Earnings do not grow, or if they do grow, they are discounted at a rate equal to their growth. This article shows a simple formula that yields a correct computation of BET. A correct BET remedies the failings of PE, allowing valuation comparisons of stocks with widely different growth rates and PEs. Moreover, it provides useful information about the sensitivity of today’s price to changes in interest rates or growth rates. BET is shown to be superior not only to simple PE but also to the ratio of PE to growth rate.

TOPICS: Performance measurement, accounting and ratio analysis, portfolio management/multi-asset allocation