On the Interpretation of P/E-Ratios in Relation to Growth

19 Pages Posted: 15 Mar 2022

See all articles by Heinz Zimmermann

Heinz Zimmermann

University of Basel - Faculty of Business and Economics

Date Written: March 1, 2022

Abstract

We analyze the necessary conditions for a positive relation between the price-earnings ratio (P/E) and expected growth, which is often claimed in financial practice, using the simple Gordon equity valuation model. The conditions are entirely based on observable valuation ratios, specifically the dividend-price (D/P) and price-to-book (P/B) ratios, respectively, the fundamentals implied by the Gordon model. A positive relationship between P/E and expected growth requires a minimum volatility (or cross-sectional variability) of P/B and D/P. While this conclusion gets, at best, some empirical support in cross-sectional comparisons of stock valuations, it fails to be adequate for temporal variations of P/E-ratios.

Keywords: Stock market valuation, price-earnings ratio, growth, valuation multiples, Gordon model

JEL Classification: G12, G32, E44

Suggested Citation

Zimmermann, Heinz, On the Interpretation of P/E-Ratios in Relation to Growth (March 1, 2022). Available at SSRN: https://ssrn.com/abstract=4046152 or http://dx.doi.org/10.2139/ssrn.4046152

Heinz Zimmermann (Contact Author)

University of Basel - Faculty of Business and Economics ( email )

Peter Merian Weg 6
Basel, 4002
Switzerland
+41 61 267 33 16 (Phone)
+41 61 267 08 98 (Fax)

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