Support for P/E Ratio of a Company

We have seen that the P/E ratio is a commonly used price multiple for valuing a company.

However, an analyst needs to analyze the P/E ratio in the larger context of the other financials of the company and need to be able to determine whether its P/E ratio is supported by the other factors.

In terms of fundamental valuation, the P/E ratio can be written as:

$P/E \text{ ratio}=\frac{\frac{D_{1}}{E}}{k-g}$

$\text{Where } P_{0}=\frac{D_{1}}{{k-g}}$

Note here that D₁/E is the dividend payout ratio, k is the required rate of return, and g is the growth rate.

Looking at this formula, we can say that:

1. Dividend payout ratio: If a company has a higher dividend payout ratio than the industry average, it supports a higher P/E ratio for the company.
2. Growth rate: If a company has a higher growth rate than the industry average, it supports a higher P/E ratio for the company.
3. Required rate of return: A lower required rate of return supports a higher P/E ratio for the company.

We can also infer that if a company has high debt, it indicates a higher required return on equity, which in turn means support for lower P/E ratio.

Using a simple analysis like this, an analyst can see what kind of support is there for P/E ratio.