Calculating earnings growth using P/E ratio
Hey all,
If this is the wrong forum category, my apologies.
Quick question:
How do you calculate future earnings using a P/E ratio. I ask this because I want to assess the future earnings a company will need to justify its current P/E ratio.
Cheers,
A P/E ratio is just a form of the Gordon growth model.
In GGM, value = Cash flow/(ke - g) where ke is cost of equity and g is the long term growth rate.
In the P/E ratio, market price is a proxy value and earnings is a proxy for cash flow.
This means a P/E ratio is conceptually the same as 1/(ke - g).
If you want to work out the future earnings, that's the earnings in the P/E, which in a P/E ratio is usually NPAT.
So you take the P/E ratio, invert it (ie it is now E/P) and multiply by share price to get E, which should be the same as the NPAT the P/E ratio was calculated on.
As the "P/E is GGM" analysis above shows, you're then assuming that earnings (NPAT) grows as a constant rate ie the long term growth rate, g.
You can see from this that P/E valuation only makes conceptual sense when you have a business with earnings growing at fairly a constant growth rate.
Great explanation, thank you.
To be specific, I am looking at Linkedin's crazy P/E. Of course, tech stocks in general associate more with exponential growth, I wonder if it would be possible to figure out the exponential growth given a P/E then. Maybe you would have to take some metric of exponential growth for an industry average and then use the multiple to translate the P/E growth into exponential growth for a tech stock. An additional question would be: Is there a valuation technique for implicit exponential growth rate's? This may make no sense. I am just curious.
ssmaclac If I'm understanding what you're saying, you are basically trying to coax the "g" out of the equation that SSits posted. If you take the inverse of the P/E ratio, which is essentially an "earnings yield" then that is the implied (r - g) implicit in the valuation. For example, a 10x P/E ratio is a 10% earnings yield. If the proper discount rate for the firm is 12%, then the valuation is implying a 2% expected growth rate in earnings. The 12% - 2% = 10%, the earnings yield.
So if the company is trading at 100x earnings, a 1% earnings yield, the implied (r - g) is 1%. You can only pin point the implied growth rate if you have the discount rate. Here you run into a bit of an issue using P/E ratios because the discount rates people use only make sense when you're talking about cash flows. So you can't just use CAPM/cost of debt to get WACC and then say that's "r" and then you have your implied "g." For net income since it represents earnings to equity after paying interest R_e from CAPM would be more appropriate proxy.
So all you can say about a 100x P/E ratio is that investors are building in some combination of a high growth rate and/or low discount rate. I think we can imagine w/ LNKD it's the former but pinning down the number isn't going to be possible. Plus then you have the fact we're assuming, in using the perpetuity growth model, that the firm lives forever. In reality, in general if you're investing in a company like LNKD (1000x P/E ratio), you're expecting huge earnings growth in short term and then moderate earnings growth in the future. So even if you worked out a certain discount rate (i.e. 20%) and then implied growth rate for LNKD is 19.9%, that doesn't say much about what the market is really expecting because people expect earnings for a company like LNKD to grow exponentially but then slow down a lot.
Makes so much sense, thank you, you guys are awesome. So pretty much all I can do is look at the P/E ratio as an indicator of expected future performance, and not as a tool to produce a valuation.
P/E is useless for high growth companies. It's ok to calculate it for your own purposes or for completing some piece of work, but do not base any assumptions on an investment decision on a start-up or high growth internet company based on P/E because you will look foolish.
PE is a pretty crappy valuation tool from a theoretical perspective, but everyone uses it nonetheless, particularly for benchmarking companies thought to have similar earnings growth trajectories. It is an indicator of valuation, but you're not going to be able to reverse a meaningful implied forecast earnings out of it as expectations are multiple stages of growth, not one sustained long term growth rate.
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