Using Time Series Analysis to Determine Appropriate Earnings Multiplier

D

The answer called for in this example is macroanalysis. This method involves an examination of the relationship between the earnings multiplier of a stock market series and the earnings multiplier of the overall market. For example, an individual projecting an earnings multiplier for a software index using macroanalysis would begin by examining the relationship between the P/E ratio of the software index and the P/E ratio of a broad market index such as the Standard & Poors

500. Both historical trends and point estimates would be examined, and from this information, a projection of the earnings multiplier for the stock market series is deduced. This is precisely the process illustrated in this example.

This is contrasted by microanalysis, which involves an examination of the components of the earnings multiplier, including the anticipated growth rate of dividends, the required rate of return, and the dividend payout ratio. Once these variables have been examined, both from the perspective of trend analysis and point estimation, a value for the earnings multiplier is deduced.

The bottom-up approach is used in the investment selection process, and involves identifying superior investments by first examining companies, rather than beginning with an examination of macroeconomic cycles and influence. Time series analysis, while materially correct, does not represent the best possible answer.