Central Value and P-E Estimation—A Formula Approach

Abstract

THE CRUCIAL PHASE OF SECURITY EVALUATION is in selection of the price-earnings multiplier. A developing thin supply of good-grade equities, and an increasing need to carefully appraise the growth factor, suggest this problem of the P-E multiplier is not to become easier. Past-applied techniques in arriving at rational multipliers have been chiefly based upon relative value or vague historical precedent, and have been highly affected by the coloration of near-term optimism or pessimism. The erratic behaviour of P-E multipliers in the past demonstrates the inadequacy of these nonobjective approaches. A search for a superior analytical and objective technique occasions this presentation of a mathematical formula approach. A mathematical formula approach to estimating proper P-E multipliers has theoretical justification. Price is a reflection of earnings and earnings outlook. Earnings outlook is related to time, amount and growth of base capital, and the rate at which capital may be profitably employed. And as long as stock investment remains an optional decision, stock price-earning multipliers should be related to existing money rates. The many factors expressed in the foregoing may be combined to fit a rational and suitable mathematical formula. Such a formula stems from the basic assumption that a proper P-E multiplier for a stock should be one that affords a future return of stock principal and interim dividends equal to bond principal and interim yield on U. S. Government obligations. Such a multiplier assumes the possibility of superior stock performance to be offset by the additional risk incurred. In equational terms this may be expressed as: