P/E Ratio and Present ValueSeptember 10th, 2010
Some investors, and perhaps also the Wall Street Journal, may not fully appreciate that the P/E ratio is just a special case of present value (aka discounted cash flow, aka DCF), in which growth is assumed to be zero. This special case is simple to understand and calculate, but comes with limitations.
When earnings growth is constant, and if earnings are initially E, then the present value is:
PV = E * (1+g)/(r-g)
…where g is growth and r is discount rate. If you assume zero growth, this simplifies to:
PV = E/r
Think about what this means. The value of earnings E is simply E divided by its required yield.
In corporate finance classes, present value, of course, typically assumes r as an input, and solves for PV. P/E ratio inverts this. PV is the independent variable, namely today’s market price P. Then solve for r to find your earnings yield:
r = E/P
Now invert this, and it starts to look familiar:
1/r = P/E
Thus you can think of P/E as a highly simplified approximation of present value, in which you assume growth is zero. But growth is never actually zero.
And what is a satisfactory required yield? Depends on your alternatives. AAA yields vary, and inflation varies. As the market attempts to incorporate changes in these competitive conditions into prices (efficiently or not), its P/E ratio naturally varies.
If this makes P/E look like a poor yardstick, remember Ben Graham’s goal in promoting it. He sought not precision, but rather simplicity and conservatism. He sought to make investing accessible to the common man.
The discounted cash flow equation is a blunt instrument, highly sensitive to tiny estimation errors in growth rate and discount rate. MBAs get wildly wrong answers all the time using DCF. By contrast, reducing investing to a simple ratio generates many false negatives, but few false positives, and thus achieves Graham’s goal of investment conservatism.