As a practical expedient investment analysts apply simple rules of thumb to establish benchmark price earnings multiples. Three popular rules of thumb used in practice are described and evaluated below:
Thumb Rule 1
The price earnings multiple or a share may be equated with the projected growth rate in earnings. For examples, if the projected growth rate in earnings for a firm is 20 percent, a price earnings multiple of 20 may be considered reasonable for it.
A popular metric used by investment analysts is the price earnings to growth ratio, popularly referred to by its abbreviation as the PEG ratio. Prima facie if the PEG ratio exceeds 1, the stock is deemed overvalued; if the PEG ratio equals 1, the stock is deemed fairly valued; and if the PEG ratio is less than 1, the stock is deemed undervalued.
This thumb rule has some merit because the projected growth rate in earnings is an important determinant of the price earnings multiple. However, it ignores the arte of return required by equity shareholders, another important determinant of the price earnings multiple. Hence, this rule of thumb is only partially supported by stock valuation theory.
Thumb Rule 2
For the market as a whole, a reasonable price earnings multiple would be the inverse of the prime interest rate (the rate of interest charged by commercial banks to prime borrowers). For example, if the prime interest rate is 12 percent reasonable price-earnings multiple for the market as a whole would be 8.33(1/0.12). This thumb rule is implicitly based on the assumption that there is no relationship between the prime interest rate and the level of corporate earnings. As the prime rate of interest is driven substantially by the rate of inflation which also has an impact on the level of corporate earnings, the key premise underlying this rule of thumb is wrong. The basic flaw in this rule of thumb is that it employs a nominal discount rate to capitalize real income.
Thumb Rule 3
For the market as a whole a reasonable price earnings multiple would be the inverse of the real rate of returns required by investors from equity stocks. For example, if the real rate of return required by investors from equity stocks is 6 percent, a reasonable price earnings multiple for the market as a whole would be 16.67 (1/0.06).
This rule of thumb stems from the arguments that equities represent claim over real assets. Hence, a rupee of equity income represents a rupee of real income. This means that the value of equity income is protected in the face of inflation. Put differently, during an inflationary period equity income will rise in nominal terms in such a way that its real value is unimpaired. Since equity income represents real income, it should be capitalized by using the real rate of return, not the nominal rate of return. The validity of this rule of thumb of course depends on whether corporate profitability is protected in real terms in the wake of inflations.
Growth and price earnings Multiple:
One often ears that a high price earnings multiple is justified because of superior growth prospects. Is this always true? To answer this question, let us look at Alpha Company which has an asset base of 100 and a net worth of 100. Alpha is an all equity financed company and wants to remain that way. Further it does not want to go in for external equity financing. Alpha’s expected turnover for the current year (referred to hereafter as year 0) is 200 and it would earn a profit after tax of 20. This means that its return on equity is 20 percent.
The financial aspects of Alpha may be analyzed for two cases:
Case A: Alpha pays its entire earnings as dividends and remains stationary (Remember that the only sinew of Alpha’s growth is retained earnings).
Case B: Alpha pays one half of its earnings as dividends and ploughs back the balance one half. As a result, it grows at the rate of 10 percent (The growth rate is the product of the retention ratio and return on equity: 0.5 X 0.02 = 0.10).