Originally Posted by melgross
I'm not saying that the entire market is irrational, but it isn't exactly logical either.
All financial formulary for valuations are ad hoc. It's decided that one thing or the other means something, and is given a value. But all of that is just assumed to mean what it means. There is no "natural" P/E, for example. It's just decided that a particular P/E is appropriate for an industry. I and whatever the actual P/E is is assumed to be "right". But that's nonsense. It's all just feelings that something is right.
While I agree that there is 'no natural PE' and that 'appropriate' PEs can vary by industry, it is far from an ad hoc formula. Indeed, it has a rather precise meaning, couched in two specific fundamentals: the return expected from the stock (which is based on its risk), and the expected long-run growth rate in earnings.
Let me explain with some simple algebra. (I will make some simplifying assumptions without any loss of generality). Assume that the Earnings (E) of a company equal its cash flows. Call the forecasted earnings for Year as1 E1, for Year 2 as E2, etc., and call the expected return on the stock 'R'.
The Price of the stock (i.e., the earnings capitalized) today is then just:
P = [E1÷(1+R)] + [E2÷(1+R)2] + [E3÷(1+R)3] + ........ ∞
Now, assume that investors can forecast (ex-post rightly or wrongly) E1. While we can certainly agree that there is no reasonable way to forecast E2, E3, etc., assume that investors (or analysts) can come up with an estimate of the long-run annual expected growth rate in earnings. Let's call it G. The formula above (applying some basic algebra) then becomes:
P = [E1÷(1+R)] + [E1×(1+g)÷(1+R)2] + [E1×(1+g)2÷(1+R)3] + ........ ∞ = E1/[R – G]
Bringing E1 to the left side,
P/E1 = 1/[R – G]
(Of course, the P/E1 is what we call the forward price-earnings ratio.)
Thus, when we use the term 'PE ratio', we are implicitly making a statement about a stock's perceived risk (the higher the risk for a given level of earnings, the lower the PE), and its earnings growth rate (the higher that number for a given level of earnings, the higher the PE -- from whence comes the notion that 'high-growth stocks have higher PEs').
Thus, when we're using a PE ratio as an indicator to buy a share we are implicitly making an assumption about its risks and growth. If we're buying it at the current PE, we're essentially saying that we're making a bet that its risk is lower than what the market currently thinks it is, and/or its earnings growth will be higher than what the market thinks it currently is.
(PS: I am not making any of this up; it can be found in most finance textbooks).
Edited by anantksundaram - 8/20/14 at 12:35pm