Price Earnings Ratio and Growth
How Growth affects the Price Earnings Ratio (PER)
Keep in mind that a price of share is given, at least in theory, by the cash flows the share promises, discounted from a rate, which is the profit the shareholder asks for.
Up until now we had made the hypothesis that the cash flow the shareholder receives are always the same. Let us suppose now that that cash flow increases each year at a constant rate.
The price of a share depends on:
- The cash flow the share promises us for the upcoming year.
- The interest rate or profit we want to obtain.
- The hoped for cash flow growth interest.
W have already seen the relation of the interest rate and risk premium with the price of the share:
- The higher the market interest rate, the lower the price we want to pay for the share will be.
- The higher the aversion to risk is, the lower the price we are willing to pay will be.
Now we can see that if the cash flow that the share promises grows, the denominator will diminish and therefore, the price we are willing to pay will be higher.
In order to relate the growth with the Price Earnings Ratio we need to create a simple hypothesis that the cash flow the share promises coincides with the Earnings per Share or the EPS.
This means that the price earnings ratio is directly related with the profit the investors are asking for and with the growth rate of the profit the investors are expecting. The investors are willing to pay a high price (a high PER) because they expect that the benefit per share grow each year. The more expectations there are of growth of the benefits the more the price will be – and therefore, the PER – they will be willing to pay. On the other hand, companies of more stable sectors and with less growth (electric and highways for example) tend to quote at a lower PER.
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