This weekend I put together a short paper (it just worked better that way than as a blog post) wherein I explain how P/E ratios are routinely misused/abused by everyone from day traders to fundamental value investors and everyone in between. The issue is when you just look at the ratio, you simply can’t understand the fundamental factors that actually drive the ratio, and they are not, contrary to popular belief, just the price on your screen and last year’s or LTM earnings.
Here, I explain why it is imperitive for traders and investors alike to understand the drivers of relative valuation ratios like P/E – free cash flow to equity, equity cost of capital, and long-term growth rate – so that comparisons between firms, across industries, and over time have context, rendering comparison and analysis far more useful than just looking at current and historical levels or averages.
I use the model to determine the implied growth rate in the S&P 500 based on its P/E and question whether there may be a large disconnect between the rate that’s priced in (the implied number) and what analysts are projecting, which is significantly higher than the implied growth rate.
This short paper will help market participants of all stripes improve their though, research, and investment selection process, and only takes a few minutes, max, to read.