PT  - JOURNAL ARTICLE
AU  - Martin L. Leibowitz
AU  - Stanley Kogelman
AU  - Anthony Bova
TI  - P/E Ratios, Risk Premiums, and the g* Adjustment
AID  - 10.3905/jpm.2019.45.4.119
DP  - 2019 Mar 31
TA  - The Journal of Portfolio Management
PG  - 119--128
VI  - 45
IP  - 4
4099  - https://pm-research.com/content/45/4/119.short
4100  - https://pm-research.com/content/45/4/119.full
AB  - This article addresses a fundamental market paradox about the role of growth in equity return forecasts. The natural starting point for any theoretical return projection is the sum of the dividend yield (DY) and earnings growth. In practice, however, this simple two-term formulation (based on a stable price-to-earnings ratio [P/E] assumption) is difficult to implement because long-term earnings growth is hard to estimate. Alternatively, many practitioners adopt the more readily observable earnings yield (EY) as a one-term equity return estimate. Unfortunately, EY alone tends to understate returns because it does not properly account for the impact of higher growth levels. In many typical cases, this understatement can be quite significant. To “true up” the EY to be consistent with the DY-based expression, an adjusted-growth term g* must be added to the EY. This g* term turns out to play a number of important roles in equity analysis. In general, g* represents the potential future earnings from value-adding investments derived from a firm’s patents, licenses, branding, market penetration, pricing power, and so on. Ultimately, the total present value of these opportunities—that is, the franchise value—is the source of premium P/Es and positive g* values. In addition to contributing to consistent going-forward estimates, the g* framework sheds light on a number of other facets of equity growth that can lead to premium P/Es.TOPICS: Fundamental equity analysis, performance measurement