Support for P/E Ratio of a Company
We have seen that the P/E ratio is a commonly used price multiple for valuing a company.
However, an analyst needs to analyze the P/E ratio in the larger context of the other financials of the company and need to be able to determine whether its P/E ratio is supported by the other factors.
In terms of fundamental valuation, the P/E ratio can be written as:
Note here that D1/E is the dividend payout ratio, k is the required rate of return, and g is the growth rate.
Looking at this formula, we can say that:
- Dividend payout ratio: If a company has a higher dividend payout ratio than the industry average, it supports a higher P/E ratio for the company.
- Growth rate: If a company has a higher growth rate than the industry average, it supports a higher P/E ratio for the company.
- Required rate of return: A lower required rate of return supports a higher P/E ratio for the company.
We can also infer that if a company has high debt, it indicates a higher required return on equity, which in turn means support for lower P/E ratio.
Using a simple analysis like this, an analyst can see what kind of support is there for P/E ratio.
- Determining the Value of a Stock
- Types of Equity Valuation Models
- Equity Valuation - Dividend Discount Model
- Equity Valuation - Free Cash Flow Model (FCFE)
- Valuation of Preferred Stocks
- Gordon (Constant) Growth Dividend Discount Model
- Calculating Stock Value Using Dividend (Gordon) Growth Model in Excel
- Dividend Growth Model: How inputs Impact Stock Value?
- Calculate Stock Price at a Future Date using Dividend Growth Model
- How to Estimate Dividend Growth Rate?
- Multi-stage Dividend Discount Models
- How Do Analysts Select an Equity Valuation Model?
- Stock Valuation Using Price Multiples
- Support for P/E Ratio of a Company
- Enterprise Value Multiples in Equity Valuation
- Asset-based Valuation Models