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.