Equity Valuation and Portfolio Management

THE LINK BETWEEN EARNINGS AND RETURNS

The P/E multiple that investors put on current earnings when valuing them, as well as other commonly used valuation metrics, shift significantly over time. Exhibit 5.1 shows the U.S. trailing P/E multiple since 1871. As can be seen, there is both a cyclical component to the changes in the multiple as well as movements at lower frequencies. The P/E multiple stayed below long term averages for most of the 1970s and above for a big part of the 1990s.

There are many potential reasons for these movements in the P/E ratio. One way to think about these drivers is to use a simple dividend discount model (DDM) with constant growth rates to measure the fair value of the market. In such a model, we have that

where P is the theoretical market price, E₀ is the level of earnings over the last year, E₁ is the level of earnings over the next year, PO is the payout ratio, R_f is the nominal risk-free interest rate, ERP is the equity risk premium, and G is the nominal growth rate.

Dividing through by E gives

EXHIBIT 5.1 The P/E Multiple has both Cyclical and Lower Frequency Movements

Therefore, changes in the P/E multiple over time could arise from changes in payout ...