Syndicate
Value Creation PER Summary
The value of money in time allows us to compare investments that promise different cash flows in the successive years and this actualizing – bringing value today – the diverse amounts we hope to receive in the future.
A share is valued by discounting the cash flow it promises to a determined K rate, which is the profit the investor demands in function of the risk of the share. The more the risk of the share the more profit the investor will demand and therefore, will only be willing to pay less for the share.
The PER is the quotient between the price of the share in a stock and the basic earnings per share; this gives us a measure of how cheap or expensive a share is. The PER is based on the discount of cash flow the share promises and assumes these cash flows are constant.
The inverse of the PER is the profit the investor will obtain. More conservative investors will want to buy at a low PER, while those that are not as conservative will be willing to buy at a higher PER.
The inverse of the PER tells us the earning power we hope to obtain, if we assume the benefits of the company are not going to vary and that all the benefits are paid to us as dividends. That demanded profit should be at least the profit of the fixed rate.
The higher the interest rate, the greater the profit the investor asks for will be and therefore, the lower the PER we are willing to pay for the share will be. And the other way around, if the interest rates are low the PER will go up.
This theoretic relation has taken place in reality. During the last twelve years and in some cities that have been studied, the PER has had a strong negative correlation with the interest rates, at – 0,6 and 0,8. In other words, the interest rates have explained between 40 and 60 for 100 of the movements of the PER. The actual low interest rates explain, amongst other reasons, the high PER of the stock in our surroundings.
However the interest rates do not justify some very high PER, and it is necessary to also take into account the hoped for growth of the benefits.
The PER depends on the profit the investor demands from the stock. And this profit depends on the levels of interest rates and the risk premium the investor asks from the stock in function of a greater or lower aversion to risk. The lower the interest rate is and the least amount of risk premium, the higher PER the investors will be willing to pay.
The relation between PER and interest rates is not lineal, so this means that when the interest rates are very low, the PER varies much more then when the rates are high.
The uncertainty of the investor make the risk premium change and therefore, this changes the PER as well. The affect of the risk premium over the PER is also greater when the interest rates are low.