Lecture 4 - Pricing Earnings Flashcards
P/E is thus based on expected growth in earnings:
- for trailing P/E: growth from current earnings onwards
- for forward P/E: growth from one-year ahead earnings onwards
P/E ratio involves a discount for risk:
- expected earning growth increases the P/E ratio
- risk reduces the P/E ratio
Creating earnings by accounting methods increases ___but reduces ___. The net effect is ___.
residual earnings but reduces book value. The net effect is zero. (e.g. writing off inventory).
V = Book Value + PV of residual earnings =
Capitalised forward earnings + PV of changes in residual earnings
Change in residual earnings =
Abnormal earnings growth
Abnormal earnings growth is the:
growth in earnings over the required growth.
Forward P/E =
Price0 / Earnings1
Trailing P/E =
(Price0 + Dividend0) / Earnings0
Normal Forward P/E =
1 / required return
Normal Trailing P/E =
(1 + required return) / required return
Normal Forward P/E =
Normal Trailing P/E - 1
Cum-dividend earnings is:
earnings with the prior year’s dividend reinvested (at the required return)
Normal earnings is:
earnings growth at the required rate of return
Abnormal earnings growth is:
the growth over normal earnings growth
AEG = Cum-dividend earnings - normal earnings
Lessons from the savings account:
- An asset is worth capitalised forward earnings if abnormal earning growth is expected to be zero
- An asset has a normal P/E ratio if abnormal earnings growth is expected to be zero
- Earnings comes from two sources: from the asset, and from reinvesting dividends
- Dividends do not affect cum-dividend earnings
- Dividend payout does not affect value
