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Some analysts use the historic PER (current price divided by most recent annual earnings), to make comparisons between firms without making explicit the considerations hidden in the analysis.
They have a view of an appropriate PER based on current prevailing PERs for other firms in the same industry. So, for example, Barclays with a PER of 16.7 may be judged to be priced correctly relative to similar firms – HSBC has a PER of 38.0, Lloyds 16.4, and Virgin Money 8.8.
Analysing through comparisons lacks intellectual rigour. First, the assumption that the ‘comparable’ companies are correctly priced is a bold one. It is easy to see how the market could be pulled up (or down) by its own bootstraps and lose touch with fundamental considerations by this kind of thinking. Good examples of this are the rise of telecommunication shares in the 1998–2000 bubble or social media companies currently.
Secondly, it fails to provide a framework for the analyst to test the important implicit input assumptions – for example, the growth rate expected in earnings in each of the companies, or the difference in required rate of return given the different risk level of each.
These elements are probably in the mind of the analyst, but there are benefits in making these explicit. This can be done with the more complete PER model which is forward looking and recognises both risk levels and growth projections.
A more complete model
The infinite dividend growth model (see last week’s newsletter – 11th January) can be used to develop the more complete PER model because they are both dependent on the key variables of growth, (in dividends or earnings), and the required rate of return.
The dividend growth model is:
Price = dividend in one year ÷ (discount rate minus growth rate)
If both sides of the dividend growth model are divided by the expected earnings for the next year then:
Price (value) now ÷ earnings in one year = (dividend in one year divided by earnings in one year) divided by (discount rate minus growth rate).
Thus we have a P/E ratio expressed as the “payout ratio” (i.e. proportion of earnings paid in dividend) divided by required return minus the growth rate
Note this is a prospective PER because it uses next year’s earnings, rather than a historic PER, which uses most recently reported earnings.
In this more complete model the appropriate multiple of earnings for a share rises as the anticipated growth rate goes up; and falls as the required rate of return increases.
The relationship with the ratio “dividend in one year divided by earnings in one year” is more complicated. If this payout ratio is raised it will not necessarily increase the PER because of the impact on expected future growth – if more of the earnings are paid out less financial resource is being invested in projects within the business, and therefore future growth may decline.
Example: Ridge plc
Ridge plc is expected to maintain a payout ratio of 50% of earnings. The appropriate discount rate for a share for this risk class is 9% and the expected growth rate in earnings and dividends is 3%.
Price (value) now ÷ earnings in one year = (dividend in one year divided by earnings in one year) divided by (discount rate minus growth rate)
P/E1 = (0.50)/(0.09 – 0.03) = 8.33
The spread between the required rate of return and the anticipated annual growth rate in earnings is the main influence on an acceptable PER. A small change can have a large impact. If we now estimate a required rate of return of 7% and a growth rate of 4% the PER doubles.
P/E1 = (0.50)/(0.07 – 0.04) = 16.67.
If the required rate of return is seen as 11% and the expected growth rate 2% then the PER is lowered to 5.6:
P/E1 = (0.50)/(0.11 – 0.02) = 5.6
The thinking behind the estimation of the growth rate is crucial. The thinking behind the estimation of the required rate of return is important, but that does not vary as much as the growth rate from company to company.
The inputs to the growth estimate are partly from the quantitative evidence of the past, but mostly qualitative elements such as strategic analysis, evaluation of managerial talent and integrity.
Example: CryptoZapp plc
You are interested in purchasing shares in Cryp
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