What Price To Earnings Ratio Depends On

The price-to-earnings ratio depends on market expectations, as unrealistic expectations can lead to overvaluation, such as the dot-com bubble, where companies like Pets.com were valued at extremely high price-to-earnings ratios despite having no earnings, ultimately resulting in their bankruptcy.

Key Dependencies

• Earnings growth rate — a steady earnings growth rate is required to justify a high price-to-earnings ratio, and without it, the ratio becomes unsustainable, as seen in the case of General Motors, which experienced a decline in earnings growth rate in the early 2000s, leading to a significant decrease in its stock price.
• Interest rates — low interest rates can increase the price-to-earnings ratio, as they make borrowing cheaper and increase the present value of future earnings, but high interest rates can have the opposite effect, as seen in the case of the 1980s, when high interest rates led to a decrease in the price-to-earnings ratio of the S&P 500.
• Risk-free rate — a high risk-free rate can decrease the price-to-earnings ratio, as it increases the opportunity cost of investing in stocks, and without a sufficient risk premium, investors may opt for safer investments, such as bonds, as seen in the case of the 2008 financial crisis, when the risk-free rate increased significantly, leading to a decrease in the price-to-earnings ratio of many stocks.
• Industry multiples — the price-to-earnings ratio of a company should be compared to the industry average to determine if it is overvalued or undervalued, and without this comparison, investors may misjudge the company's valuation, as seen in the case of Amazon, which has a high price-to-earnings ratio compared to its industry average, but is still considered undervalued by many investors due to its high growth rate.
• Growth prospects — a company's growth prospects are critical in determining its price-to-earnings ratio, and without strong growth prospects, the ratio may not be justified, as seen in the case of Kodak, which failed to adapt to the digital camera revolution and experienced a significant decline in its stock price.
• Inflation expectations — high inflation expectations can decrease the price-to-earnings ratio, as they increase the discount rate used to calculate the present value of future earnings, and without a sufficient adjustment for inflation, investors may overvalue a company's stock, as seen in the case of the 1970s, when high inflation expectations led to a decrease in the price-to-earnings ratio of many stocks.

Priority Order

The dependencies can be ranked in the following order from most to least critical:

• Earnings growth rate, as it directly affects the sustainability of the price-to-earnings ratio
• Interest rates, as they affect the cost of borrowing and the present value of future earnings
• Risk-free rate, as it affects the opportunity cost of investing in stocks
• Growth prospects, as they affect the company's ability to generate future earnings
• Industry multiples, as they provide a benchmark for evaluating the company's valuation
• Inflation expectations, as they affect the discount rate used to calculate the present value of future earnings, but are often already incorporated into interest rates and earnings growth rate expectations.

Common Gaps

People often overlook the cyclicality of earnings, assuming that a company's earnings will continue to grow at a steady rate, and fail to account for the impact of interest rates on valuation, assuming that interest rates will remain low indefinitely, which can lead to overvaluation and significant losses when interest rates rise, as seen in the case of the 2008 financial crisis, when many investors failed to account for the impact of rising interest rates on the valuation of mortgage-backed securities.