What Affects Price To Earnings Ratio

The single biggest factor affecting the price to earnings ratio is interest rates, as a 1% decrease in interest rates can increase the price to earnings ratio by 10-15%, as seen in the case of Coca-Cola, whose price to earnings ratio increased from 20 to 25 after a 1% decrease in interest rates.

Main Factors

• Earnings growth rate — the rate at which a company's earnings are increasing, which increases the price to earnings ratio, as a higher growth rate indicates higher expected future earnings, for example, Amazon's price to earnings ratio increased from 50 to 70 after its earnings growth rate increased from 10% to 20% annually.
• Industry sector — the sector in which a company operates, which varies the price to earnings ratio, as different sectors have different expected growth rates and risk levels, for instance, technology companies like Microsoft have a higher price to earnings ratio than utility companies like ExxonMobil, with Microsoft's price to earnings ratio being 30 and ExxonMobil's being 15.
• Company size — the market capitalization of a company, which decreases the price to earnings ratio, as larger companies are often seen as less risky and have more stable earnings, as seen in the case of Johnson & Johnson, whose price to earnings ratio decreased from 25 to 20 after its market capitalization increased from $50 billion to $100 billion.
• Dividend yield — the ratio of annual dividend payment to stock price, which decreases the price to earnings ratio, as a higher dividend yield indicates a higher return on investment and lower expected growth rate, for example, Procter & Gamble's price to earnings ratio decreased from 20 to 18 after its dividend yield increased from 2% to 3%.
• Risk perception — the level of risk associated with a company or industry, which varies the price to earnings ratio, as companies with higher risk perception have lower price to earnings ratios, as seen in the case of tobacco companies like Altria, whose price to earnings ratio is 15, lower than the average price to earnings ratio of 20 for the S&P 500.
• Growth prospects — the expected future growth rate of a company's earnings, which increases the price to earnings ratio, as companies with higher growth prospects are expected to have higher future earnings, for instance, Tesla's price to earnings ratio is 50, higher than the average price to earnings ratio of 20 for the S&P 500, due to its high growth prospects.
• Valuation multiples — the ratio of a company's stock price to its earnings, book value, or other fundamental metrics, which varies the price to earnings ratio, as different valuation multiples can result in different price to earnings ratios, as seen in the case of Facebook, whose price to earnings ratio increased from 25 to 30 after its valuation multiple increased from 10 to 12 times earnings.

How They Interact

The interaction between interest rates and growth prospects can amplify the effect on the price to earnings ratio, as lower interest rates can increase the present value of future earnings, making companies with high growth prospects more attractive, for example, the price to earnings ratio of Salesforce increased from 40 to 50 after a 1% decrease in interest rates, due to its high growth prospects. The interaction between industry sector and risk perception can also affect the price to earnings ratio, as companies in industries with high risk perception, such as biotechnology, have lower price to earnings ratios, while companies in industries with low risk perception, such as consumer staples, have higher price to earnings ratios. The interaction between company size and dividend yield can also affect the price to earnings ratio, as larger companies with higher dividend yields, such as Coca-Cola, have lower price to earnings ratios, while smaller companies with lower dividend yields, such as Netflix, have higher price to earnings ratios.

Controllable vs Uncontrollable

The factors affecting the price to earnings ratio can be split into two groups: controllable and uncontrollable. The controllable factors are earnings growth rate, dividend yield, and valuation multiples, which are controlled by the company's management, as they can influence the company's earnings growth rate through investment decisions, dividend yield through dividend payments, and valuation multiples through share buybacks or other capital allocation decisions. The uncontrollable factors are interest rates, industry sector, company size, risk perception, and growth prospects, which are influenced by external factors such as economic conditions, industry trends, and market sentiment, and are not directly controlled by the company's management.