Price/Earnings Ratios and Future Growth of Earnings and Dividends

Abstract

O NE OF THE most important market ratios used in valuation of common stocks is the price/earnings ratio, or the P/E ratio. The advantage of the P/E ratio is that it permits immediate comparison of the prices of an unlimited number of stocks in terms of a common earnings base. The importance of this advantage is evident in the daily use of the P/E ratio by professional investors, its widespread publication by investment research services, its use by investment bankers in pricing new equity securities, its frequent presence in court in the appraisal of the value of closely held securities and its incorporation in most theoretical and empirical models of the determinants of common stock prices. At any given time P/E ratios vary widely from one common stock to another. Besides being influenced by the level of earnings, the price of a stock, and consequently its P/E ratio, may be influenced by a number of other variables such as risk, company size, debt/equity ratio, industry, dividend yield, past growth of earnings, past growth of dividends, expected future growth of earnings and anticipated growth of dividends. Of these other variables probably the most important is growth of earnings and dividends. Growth is an important variable in the theoretical and empirical models of most writers, such as Benishay, Gordon, Graham, Dodd and Cottle, Holt, Lerner and Carleton, Whitbeck and Kisor and Williams, to cite a few. Different P/E ratios may be accorded to different stocks principally on the basis of expected future rates of growth of earnings and dividends. The reason for this differentiation is that a rising future earnings stream is considered to be worth more than a falling one. Graham, Dodd and Cottle, for example, assert that P/E multipliers should advance proportionately ... as the expected growth rate rises ..1 Holt argues that companies with high growth rates of earnings should be valued higher than companies with low growth rates....1 Whitbeck and Kisor stipulate that .. we should be willing to pay more, in terms of price earnings multiples . for stocks whose earnings growth will be more rapid ..3 The question of the actual relation between relative P/E ratios in one period and growth of earnings and dividends in a succeeding period is extremely important. Knowledge of the relationship should provide an indication of the ability of the market to judge future growth of earnings and dividends, assuming that the market tends to appraise future growth through the P/E ratio. The relation of past P/E ratios to future growth of earnings and dividends also has a bearing on the determinants of stock prices and in stock price models. A great deal of theoretical work has been done to elucidate the relationship of future growth of earnings and dividends to present value or present price. Extensive empirical work has also been done to reveal the relationship of past growth of earnings and dividends to price and to P/E multiples. Yet very little empirical work has been done on the relation of future earnings and dividend growth to past P/E ratios, the subject of this article. Only one previously published study examined this important question. In accord with traditional assumptions it found that earnings gains are greatest in the high P/E group.4