The effect of growth rate on P/E

One of the major determinants of the intrinsic value of a stock which is used by investors who practice fundamental analysis is the expected growth rate. The larger the growth rate of dividends and earnings(all other things being equal), the higher price an investor will be willing to pay for a stock. In addition to the growth rate, investors will also want to know the duration of the expected growth rate. The longer a high growth rate is expected to continue, the higher a price the investor will be willing to pay for a share of a company.

It all sounds straightforward, but predicting the future earnings as well the duration of the growth rate is not a simple or precise process. This is due to the fact that predictions about the future are by their nature subject to large errors. Depending on what predictions you make, you can convince yourself that a stock is a good buy at a wide range of prices. Investors do not have a perfect crystal ball that allows them to accurately see into the future.

A study conducted by John Cragg and Burton G. Malkiel demonstrated that stocks that have high estimated growth rates also tend to have higher P/E multiples. P/E multiples can be used to compare different stocks rather than comparing individual stock prices because it tells you more about how the market is valuing each stock. Investors can compare the P/E and the estimated growth rate of different stocks which may help identify stocks that warrant more research. For example, if two companies in the same industry have the same projected growth rate of 10% for the next 5 years but one is currently selling for a P/E ratio of 25 while the other has a P/E ratio of 30, the one with the lower ratio might be a more attractive buy and warrants further research to determine why this difference exists. The same logic applies when making decisions about selling one of your stocks. If it has a much higher P/E ratio than similar companies in the same industry for a given growth rate and your research uncovers no reason for that it might be a good time to consider selling.

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