A Fresh Look at the P/E Ratio
By S.P. Brown

The price-to-earnings (P/E) ratio is the most elementary of all financial ratios; it's nothing more than the annual earnings per share (EPS) divided by the current market price. Simple enough.

For many investors, though, the P/E ratio is the first valuation measure applied when screening stocks. If a stock's P/E ratio is lower than the market average, it may be considered to be undervalued. On the other hand, if it's higher than the market average, it may be considered to be overvalued.

A P/E ratio is a function of a company's expected rate of EPS growth, its required rate of return and its dividend-payout ratio. Assuming equal risk and no significant difference in the payout ratio for different firms, the principal variable affecting differences in the earnings multiple for two companies is the difference in expected growth.

Still, a straight P/E ratio comparison has its limitations. Trying to compare a P/E ratio for a growth company directly to a market index is often a futile exercise because it offers little insight to investor's growth duration expectations for the stock.

A better technique is to compare a company's P/E ratio to the market's P/E to arrive at an implicit measure of how long investors expect the growth company to grow faster than the market.

The fact is, no company can grow indefinitely at a rate substantially above the norm. For example, Cisco Systems can't continue to grow earnings per share at an average rate of 39 percent indefinitely, or it will eventually become the entire economy.

Cisco, or any similar growth company will eventually run out of high-profit investment projects because continued growth at a constant rate requires that larger amounts of money be invested in high-return projects.

Eventually, competition will encroach on these high-return investments, and the firms growth rate will decline to a rate consistent with the rate for the overall economy. Therefore, ascertaining the duration of a company's high-growth period is an important calculation.

The growth duration model attempts to quantify how long investors are expecting the EPS of a growth stock to grow faster than the market. Once the growth duration is calculated, an investor can then determine whether the implied duration estimate is reasonable given the company's potential.

Consider Cisco again. The company's stock is selling around $55 per share. It's average EPS growth rate over the past five years is 39 percent. What's more, the company has a P/E ratio of 150 and pays no dividend. In contrast, the S&P 500 Index has a five-year average EPS growth rate of 20 percent, a P/E ratio of 23 and pays a dividend that yields 1.5 percent.

Therefore, the comparison looks like the following:

Cisco Systems S&P 500 P/E ratio 150.000 35.000 Average growth rate .390 .200 Dividend yield .000 .015

Now, the growth duration equation using Cisco and S&P 500 variables is (the secret is to solve for the letter "T," which stands for time):

ln (150/35) = T*ln (1 + .39 + 0)/(1 + .20 + .015)

This simplifies to:

ln (4.286) = T*ln (1.144)

After another iteration, the equation becomes:

T = ln (4.286) / ln (1.144)

Note: ln stands for log base 10. To calculate this number using a Hewlett-Packard 12C calculator, enter the number (4.286 or 1.144) then hit the keys g and LN, then hit g, LN and then the divide key.

T = .6321 / .0584

T = 10.77

So, according to this calculation, based on current P/E ratios and average historical growth rates for Cisco and the S&P 500, investors are expecting the networking equipment king to grow faster than the S&P 500 for the next 10.77 years.

A few caveats. When employing the growth duration model, investors need to consider that the model assumes equal risk. It also assumes that stocks with higher P/E ratios have higher growth rates, which isn't always the case. In some instances a stock sports a high P/E ratio because of differences in risk, inaccurate growth estimates or overvaluation.

Nevertheless, despite these shortcomings, the model goes a long way to providing some insight into many of those sky-high P/E ratio stocks.