Friday, 13 November 2009

****Earnings Multiples by Aswath Damodaran

PE Ratio and Fundamentals

Proposition: Other things held equal, higher growth firms will have higher PE ratios than lower growth firms.

Proposition: Other things held equal, higher risk firms will have lower PE ratios than lower risk firms

Proposition: Other things held equal, firms with lower reinvestment needs will have higher PE ratios than firms with higher reinvestment rates.

Of course, other things are difficult to hold equal since high growth firms, tend to have risk and high reinvestment rates.

PEG Ratios and Fundamentals: Propositions

Proposition 1: High risk companies will trade at much lower PEG ratios than low risk companies with the same expected growth rate.

• Corollary 1: The company that looks most under valued on a PEG ratio basis in a sector may be the riskiest firm in the sector

Proposition 2: Companies that can attain growth more efficiently by investing less in better return projects will have higher PEG ratios than companies that grow at the same rate less efficiently.

• Corollary 2: Companies that look cheap on a PEG ratio basis may be companies with high reinvestment rates and poor project returns.

Proposition 3: Companies with very low or very high growth rates will tend to have higher PEG ratios than firms with average growth rates. This bias is worse for low growth stocks.

• Corollary 3: PEG ratios do not neutralize the growth effect.

Relative PE: Definition

The relative PE ratio of a firm is the ratio of the PE of the firm to the PE of the market.

Relative PE = PE of Firm / PE of Market
While the PE can be defined in terms of current earnings, trailing earnings or forward earnings, consistency requires that it be estimated using the same measure of earnings for both the firm and the market.

Relative PE ratios are usually compared over time. Thus, a firm or sector which has historically traded at half the market PE (Relative PE = 0.5) is considered over valued if it is trading at a relative PE of 0.7.

The average relative PE is always one.

The median relative PE is much lower, since PE ratios are skewed towards higher values. Thus, more companies trade at PE ratios less than the market PE and have relative PE ratios less than one.

Read: 103 slides on earnings multiples

No comments: