Personal Finance & Money Stack Exchange is a question and answer site for people who want to be financially literate. It only takes a minute to sign up.
Sign up to join this community
I think it was a rule of thumb that came from T. Rowe Price: if year-after-year growth of earning per share (EPS) is 10%, then its P/E ratio could be 10, as expected by people and seen as reasonable.
If EPS growth is 40%, then a P/E ratio of 40 is ok and reasonable.
What basis of reasoning or principle does this rule of thumb have? It may sound somewhat arbitrary or gut-feeling like, first knowing this rule of thumb.
Companies with stable, positive earnings that are not expected to grow are not worthless. 0% growth does not imply 0 P/E.
I'm not sure I agree with the implication, but I believe he is saying that if EPS grows by 40%, and you find that the current price of the stock has a P/E ratio of 40, then that is "okay and reasonable."
Let's say a stock was $10, and had a 10% EPS of $1 per share. Its P/E ratio would be 10.
Assuming the EPS grew 40% to $1.4 per share, T. Rowe Price seems to be claiming that you should be "ok" with buying it at it at its new price given it had P/E ratio of 40.
The new price would be $56.
I'm assuming he is suggesting that the company is growing fast, and the rapid rise in stock price shouldn't scare you away.
I wouldn't agree with this until I understood how they were able to increase the EPS. You would want to look at their financial statements, there is a lot of freedom to play around with numbers to increase earnings when a company is not actually growing.
Fundamentally, the investor must decide how many years to look forward. A company is often valued at some-number-of-years times the current earnings.
But, for example, the company has $1 in earnings per-share and a 10% earnings growth and so include the 10% earnings growth by some means:
Valued at the current year's earnings along with four-year's forward earnings, the valuation is $1.22 average-annual-earnings times 5 years or $6.1 . Then the P/E ratio based on current earnings is 6.1 . Or the P/E ratio is 5 based on the expected average annual earnings for the five-year period.
Valued at the current year's earnings along with nine-year's forward earnings, the valuation is $1.59 average-annual-earnings times 10 years or $15.90. Then the P/E ratio based on current earnings is 15.9 . Or the P/E ratio is 10 based on the expected average annual earnings for the ten-year period.
Then calculate the 10 year period valuation with $1 in earnings per-share and 20% earnings growth and the valuation is $25.96. Then the P/E ratio is 25.96 as based on current earnings. Compare the P/E ratio increasing from 15.9 to 25.96 as the earnings growth increased from 10% to 20%. The P/E ratio did not double as the earnings growth doubled. (Eleven year's valuation of 20% earnings growth produces a P/E ratio of 32.12 but there is really no particular target that must be hit.)
Now if the earnings growth is known what is missing in this subject is the profit-margin which is not known. Then realize that an increase in profit-margin represents a higher price-to-sales ratio. One point here is that a high price-to-sales ratio does not necessarily represent an expensive stock. A higher profit-margin can produce the same amount of earnings with less revenue. But in this subject the profit-margin is fixed and the earnings growth is known which means that the revenue growth and the earnings growth are the same percentage.
