Earnings Multiplier Calculation

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To determine the earnings multiplier, or "P/E ratio," of a stock market series, use the following equation: P/E = [(D1 / E1) / (k-g)

Where: D1 = the annual per-share dividend at t1, E1 = the EPS figure at t1, k = the required rate of return on common stock, and g = the expected growth rate of dividends.

In this example, all of the necessary information has been provided, and putting it into the equation above will yield the following:

P/E of a stock market series = [($1.20*1.06 / ($3.35*1.06)) / (0.085 - 0.06)] = 14.33

This earnings multiple is appropriate for lower growth industries, such as the grocery business, which has historically grown in the mid-to-high single digits for much of the last decade. Consider the fact that the P/E ratio is a proxy for future growth. Firms in the automobile, basic materials, or other mature industries, which are expected to grow slowly, are characterized by lower earnings multiples and higher dividend payout ratios. Firms in the software, networking, biotechnology, and other high-growth industries, are typically characterized by high earnings multiples and low dividend payout ratios. What is happening here is that investors are giving up current income (i.e. dividends) in the hopes of rapid earnings growth (i.e. greatly increased EPS in the future).

A complete understanding of this relationship is absolutely crucial, and as a Level 1 candidate, I encourage you to examine this relationship further if you are not completely comfortable with the P/E ratio, its components and the relationships between them, and the implications of the earnings multiplier across different industries. Indeed, the P/E ratio is a valuable tool, one which can provide significant information about the growth prospects priced into a common stock.