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The P/E or price to earning ratio is a common tool to judge the relative price of shares. The trouble is that a high P/E ratio could be a sign of an overvalued stock but it could also just mean that the expected future profits are very big. So current profits are low relative to the stock price but the market expects that profits will be growing and relative to these future profits the current stock price is more reasonable.

My question is whether there are some investment guides that try to put these future expectations into some concrete formulas that allow you transform the P/E ratios into expected future profits or some expected growth rate of the current profits or something like that.

So with example numbers, company A made $100 million profit last year and has a total market value of $2 billion for a P/E ratio of 20. Company B also made $100 million profit last year but has a total market value of $4 billion for a P/E ratio of 40. Let's assume that the general expectation is that profits for company A will stay mostly constant for the foreseeable future. Profits in company B are expected to grow but can one put a number on that based on the current stock price (possibly relative to company A)?

The idea is to use this number and compare with my personal beliefs about the future growth potential to decide which stock to buy. Of course that still requires predictions about the future but it seems judging whether company B's profit will increase by more or less than say 20% per year for the next 5 years seems more tangible that judging whether a P/E ratio of 40 is too high or too low.

I'm pretty sure others must have had this idea before so some reference to a named investment strategy trying to do that or something like that would be very useful as well.

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You might start with a Total Payout Model, which is a small extension of the the Dividend Discount Model and its usual application the Gordon Growth model.

Price(t) = d x Earnings(t+1) / (r - g)

This expression assumes earnings grow at a constant rate, g, in perpetuity, that the cost of equity capital is r, and that d is the fraction of earnings distributed to shareholders via a dividend or share buyback (i.e., the payout ratio).

Divide both sides of the expressions by Earnings(t+1) and you get the prospective P/E ratio.

Price(t) / Earnings(t+1) = d / (r - g)

This expression tells us the drivers behind P/E ratios:

  1. how much the company pays its shareholders,
  2. the equity expected return, and
  3. the growth of earnings.

In this model, if you want to say that a stock is overvalued because it has a high P/E ratio, you're really saying that the market has overestimated the payout ratio or the growth of future earnings, or underestimated future expected returns (interest rates and risk premia).

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  • I think you have a sign mixup, it should be (g-r) not the other way round. As written the price turns negative if g > r, meaning my earnings grow faster than the cost of capital. If g < r, the business is burning money and they would be better off shutting down and investing the money elsewhere.
    – quarague
    Commented Jul 13 at 11:57
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    It’s correct and g must be less than r for the model to make sense.
    – MRR
    Commented Jul 14 at 12:44
  • @quarague You are wrong - if growth is forecasted near or above the cost of capital, the model implies infinite / nonsensical results. Assume you receive $1,000 in dividends per year. Assume the appropriate rate of return for your investment is 10% [so, higher than the cost of debt, but not outrageous]. With no company growth, this would be worth $1,000 / 10% = $10,000. If the company is expected to grow 1% / year, then it would be worth $1,000 / 9% = $11,111. If the company is expected to grow 9.9% per year [just barely shy of the cost of capital], the dividend stream would be worth $1M.
    – Grade 'Eh' Bacon
    Commented Jul 17 at 13:10
  • @quarague in particular, this statement of yours is wrong "If growth is < cost of capital, the company is burning money, and that money should be invested elsewhere". No. If the total dividends as a % of initially invested capital, is less than cost of capital, then money should be invested elsewhere. What is being talked about here, is simply the growth rate of those dividends, which should then be compared against the initial investment amount.
    – Grade 'Eh' Bacon
    Commented Jul 17 at 13:14

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