Relative PE Ratios and Market Growth

Relative PE Ratios and Market Growth

As the expected growth rate on the market increases, the divergence in PE ratios increases, resulting in a bigger range for relative PE ratios.

This can be illustrated very simply, if you consider the relative PE for a company that grows at half the rate as the market.

When the market growth rate is 4%, this firm will trade at a PE that is roughly 80% of the market PE. When the market growth rate increases to 10%, the firm will trade at a PE that is 60% of the market PE.

This has consequences for analysts who use relative PE ratios. Stocks of firms whose earnings grow at a rate much lower than the market growth rate, will often look cheap on a relative PE basis when the market growth rate is high, and expensive when the market growth rate is low.

http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf