The expressions developed in such an exercise are interpreted as the justified (or based on fundamental) values for a multiple.
The justified P/E Ratio:
P/E = D/E/(r-g)
r = required rate of return
g = growth
Gordon Growth Model
r = D/P + g
D/P = r-g
P/E = D/E(r-g)
P/E = Dividend Payout Ratio / (r-g)
The P/E ratio is inversely related to the required rate of return.
The P/E ratio is positively related to the growth rate.
The P/E ratio appears to be positively related to the dividend payout ratio.
- However, this relationship may not always hold because a higher dividend payout ratio implies that the company's earnings retention ratio is lower.
- A lower earnings retention ratio translates into a lower growth rate.
- This is known as the "dividend displacement" of earnings.
Higher the growth rate (g), higher the P/E.
Higher the required rate of return (r), lower the P/E.
Higher the DPO ratio, higher the P/E.
Also, higher the DPO ratio, lower the retained earnings, leading to lower growth rate (g), thus lower P/E. ("dividend displacement" of earnings)