The P/E ratio can be seen to be effected by the following major factors :
i) Effect due to perceived growth opportunities -PVGO:
The P/E can be also depicted by the equation
P/E = 1/k[1 + (PVGO / (E/k))].
When future growth opportunities dominate the estimate of the total share price , the share price will be higher relative to the current earnings. Thus, a firm having an expectation of high growth opportunities will show a high P/E.
ii) Effect due to high ROE :
P/E equation can also be written as :
P/E = [(1-b)]/[(k – ROE x b)]
Where b is the reinvestment rate.
The equation shows that the increasing ROE decreases the denominator and thus increases the P/E ratio. Thus firms having a higher ROE will have a higher P/E ratio. However, it is assumed that the reinvestment of earnings into the business gives higher returns than the investor required returns k.
iii) Effect due to riskier business :
P/E equation as given above can be written as :
P/E = [(1-b)]/[(k – g)]
Where g=ROE x b , the dividend growth rate. When the business of the firm is riskier as compared to another firm , the investor expected return demanded is more i.e k is higher. This reduces the denominator and thus results in lower P/E.
iv) Effect due to changes in stating earnings :
The earnings part in the P/E equation can be influenced by the way depreciation is calculated, inventory valuation is done etc. Also , how revenue is recognized can impact the earnings. These treatments effect the P/E ratio .
v) Effect due to the β of the stock :
The macro economic factors tend to impact the firms and their earnings differently. Thus the firms having higher β will show higher earnings on a positive business cycle trend as compared to a lower β value stock and a much lower earnings when the business cycle is unfavorable. Thus the P/E ratio will fluctuate much higher as the earnings part is much influenced due to higher β
