What Wall Street sees when it looks at your P/E ratio.

• Author: Clemente, Holly A.
• Position: Price/earnings ratio - Analysis of financial statements

What Wall Street sees when it looks at your P/E ratio

What goes into the analysis that potential investors apply to your financial statements? Read on for a primer on the often complex formulae that spell "yeah" or "nay" to investing in your firm. The executive turned to the financial analyst and inquired why their company's price/earnings ratio was below those in their peer group. The analyst produced a graph of the historically up-and-down earnings pattern of the company and, indicating the lowest point on the graph, replied, "I think this is where we went wrong."

If you review the price/earnings ratio's relationship to the four principle methods of stock valuation, earnings emerge as a primary driver of a company's stock price. Earnings have many characteristics. Current and expected earnings, consistency, quality, momentum, sustainability, as well as the role of earnings in cash flow analysis, are all important aspects of the role of earnings in stock valuation.

Stock valuation models are used extensively by institutional researchers and investors to identify investment candidates. These models reflect four concepts: dividend discount, asset valuation, cash flow analysis, and relative valuation.

Model #1: Dividend discount

The dividend discount model values a stock price as the present value of the stock's future dividend stream, discounted by the current interest rate. If an investor in an equity instrument expects to derive returns over the long term from the net income of a corporation in the form of dividend or asset accumulation, he has to look to the future for the expected return.

The tool most often used in determining the expected return is the P/E ratio. The P/E ratio is defined as the mechanism in which present earnings are capitalized. For example, if a company earns $1.50 per share for a given fiscal year and the stock price is $15 per share, the investor is willing to pay 10 times the current earnings to become an owner of the company.

If the company continues to earn $1.50 for a very long time, the investor will receive a 10-percent return on the original investment (earnings/price paid), which the company either distributes in dividends or uses to increase assets. However, if the earnings of the company grow by 10 percent per year, everything else being equal, the company would earn $3.00 per share seven years later. The return on the original investment would actually be 20 percent. This example introduces the element of expected growth into the formula of determining the P/E multiple, the actual rate of the capitalization of earnings.

Current earnings and expected earnings, as illustrated in the previous example, are two of the three variables that influence the P/E ratio. Since companies do not operate in a vacuum, a third variable, the general market valuation, is introduced.

The general market valuation is the value of alternative investment opportunities. Alternative investment opportunities are driven by the prevailing level of interest rates. Even if management performs well, a stock price may languish because the discount factor investors apply to its dividend and earnings prospects may increase due to rising Treasury bond yields and the increased risk attributed to investors holding diversified portfolios of...