The Price/Earnings Ratio,
Growth, and Interest Rates:
The Smartest BET
Preston W. Estep
P reston W. Estep ABSTRACT: The price/earnings ratio (PE) is
is a managing member the most ubiquitous measure of investment value. It
at Battenkill LLC in
appears to tell us how many years would be required
St. Louis, MO.
tony@arbtrade.net for accumulated earnings to equal today’s price (the
break-even time [BET]), but that interpretation is
built on unrealistic assumptions about a company’s
future: Earnings do not grow, or if they do grow,
they are discounted at a rate equal to their growth.
This article shows a simple formula that yields a
correct computation of BET. A correct BET rem-
edies the failings of PE, allowing valuation com-
parisons of stocks with widely different growth rates
and PEs. Moreover, it provides useful information
about the sensitivity of today’s price to changes in
interest rates or growth rates. BET is shown to be
superior not only to simple PE but also to the ratio
of PE to growth rate.
TOPICS: Performance measurement,
accounting and ratio analysis, portfolio man-
agement/multi-asset allocation*
T
he price/earnings ratio (referred
to hereafter as PE) is one of the
simplest and most ubiquitous of
all investment metrics. It tells
you how much you are paying for a dollar
of today’s earnings; viewed another way, PE
is a representation of break-even time (BET),
*All articles are now the number of years it would take for earn-
categorized by topics ings to add up to today’s price. However,
and subtopics. View at
PE represents that number of years only in
PM-Research.com.
September 2019
the special case when earnings never change
and interest rates are zero or, more gener-
ally, when the rate of growth of earnings and
the interest rate at which future earnings are
discounted are exactly equal.
This implicit assumption is restric-
tive and unrealistic. Money that will not be
earned until years in the future has to be
discounted to present value. Moreover, stock
investors generally expect earnings to grow
over time and (hopefully) at a rate faster than
the rate of interest. Companies whose earn-
ings are expected to grow faster than others
should, and usually do, sell at higher PEs.
The challenge of any valuation scheme is to
incorporate earnings, future growth, and
interest rates to provide a metric that can be
used to compare all stocks.
This article explores the benefits of
remedying the weaknesses of PE by correctly
applying the concept of PE as the time
required for the present value of accumu-
lated future earnings to equal today’s price.
This notion of time to break even is often
associated with capital budgeting analysis
(Weingartner 1969), and we shall see that it
is superior to PE and other simple common
stock valuation methods.
To make BET valid, it must include an
explicit estimate of earnings growth and an
explicit discounting process. Of course it is
possible to overcomplicate the calculation
with multiple growth and interest rate curves,
The Journal of Portfolio Management   139
requiring an elaborate computer model. However, we g = 9.0%, i = 3.0%
will show how to obtain an accurate BET with a for-
mula that does not require many forecasts and can be Therefore, PE = 20 and r = .0582. Now computing
computed on a hand calculator. BET:
Correctly calculated, BET offers an intuitively
understandable valuation comparison that is valid for  0.0582  
ln  1 + 20 
all types of stocks, even though they may have quite   1.0582  
different growth expectations and current PE levels. Our BET = = 13.1
ln(1.0582)
BET formula also has an extra benefit; because it can
be differentiated, it permits analysis of the sensitivity of In this case, the PE of 20 is about 1.6× the BET—
a stock’s price to changes in expectations and investor that is, the payback time when accounting for growth
risk appetite. This means that it gives us more than just and discounting.
a static valuation comparison. It allows for a dynamic We can make BET even easier to use by invoking
analysis of the prospects of different stocks to changes two shortcuts that simplify the calculation with little
in the market environment, including not only changes sacrifice of accuracy. First, with a modest loss of accu-
in discounting and growth rates but also changes in the racy, the calculation of r can be reduced to simply
time horizon that investors are willing to accept when
evaluating future earnings growth. r = g –i

A FORMULA FOR BET Furthermore, Equation 2 can be approximated as

To compute BET we start by writing the desired ln(1 + r PE )

BET =
equality between today’s price and the discounted value ln(1 + r )
of future earnings over n years:
This is the most practical form for general use.
BET
It provides essentially the same improvement over simple
P= ∑E (1 + r )
y
(1)
PE offered by the more complicated versions. Using this
y =1
formula gives a BET of 13.5, which is not too far (+3%)
where P = today’s price per share; E = trailing 12-month from the precise calculation. This calculation should
earnings per share; g = estimated growth of earnings; be used in preference to PE for valuation comparisons.
i = discounting rate; r = 11++gi − 1; and BET = years to break
even, the desired measure of BET. THE MYSTERIOUS TRADE-OFF:
For notational convenience, define R = 1 + r. PE VERSUS GROWTH
Solving Equation 1, we find that BET can be written
as follows: A principal purpose of BET is to provide some
basis for value comparisons of companies with differing
 R − 1  growth rates. It seems clear that a higher expected growth
ln  1 + PE 
  R   rate deserves a higher current PE, but how much higher?
BET = (2) BET seeks to answer that question. Exhibit 1 provides
ln(R )
a picture of the trade-off between PE and growth. The
Current price
where PE = Trailing 12−month EPS horizontal axis shows today’s PE, and the vertical axis
shows what growth rate would be required to achieve
(For proof of Equation 2, see the online Appendix) a given BET, as represented by the plotted lines. (In
To illustrate how the correctly calculated payback all cases, the interest rate is assumed to be 3.0%.) For
time BET may differ from the naïve payback estimate example, a stock selling at a PE of 21 will have a BET
obtained by simply dividing price by earnings, consider of 12 years if the growth rate is 11.3% (the circled point
this sample BET calculation: on the plot). In a static world, every stock on one of the
“isoBET” lines offers equivalent value to the investor;
P = 40, E = 2.00

140   The Price/Earnings Ratio, Growth, and Interest Rates: The Smartest BET September 2019
Exhibit 1
Growth/PE Trade-Off for a Given BET

*URZWK5DWH5HTXLUHGIRU,QGLFDWHG%(7 ,QWHUHVW5DWH  %(7 
%(7 
%(7 

%(7 
%(7 










       
&XUUHQW3(

that is, if all estimates are realized, each of the six stocks Exhibit 2
on the BET = 12 line will recoup the initial purchase The Misleading PEG Ratio
price via earnings in the same 12-year period. Note
that the slope of the isoBETs becomes f latter as BET 6WRFN (36 3ULFH 3( ([SJ ,QW5DWH 3(* %(7
increases. As valuations become richer, small increases 3       
in growth can be accompanied by large increases in PE. 3       
3       

PEG DOES NOT DO THE JOB

Note: EPS = earnings per share; Exp g = expected growth; Int Rate =
interest rate.
Note the column “PEG” in Exhibit 2. This refers
to the PEG ratio, PE divided by 100× the expected
growth rate (Farina 1969; Trombley 2008). This also Stock P1 in Exhibit 2 is selling at a PE of 15 and
represents an attempt to describe how much PE should has a payback period BET of 13.9. Dividing its PE of
be affected by increased growth. However, it is not 15 by 100× expected growth of 3% gives a PEG of 5.0.
clear what the PEG ratio actually represents. What are Stocks P2 and P3 also have a PEG of 5.0, but their
the units of the PEG ratio? The units of PE are years, required payback periods are about 40% longer. In the
and the units of the growth rate are percentage/year. case of P2, both price and growth are twice that of P1.
Dividing PE by growth therefore gives a result denomi- This maintains PEG at its same value but increases BET
nated in years2/percentage, a nonsense quantity. If the from 13.9 to 19.7, dramatically reducing the attractive-
units do not make sense, we know we cannot have ness of the stock. In the case of P3, the price and growth
the right answer. Exhibit 2 shows just how misleading rates are the same as P1, but now the interest rate is 6%
PEG can be.

September 2019 The Journal of Portfolio Management   141

rather than 2%. Again, the BET is greatly extended.
This example not only illustrates the inadequacy of the
PEG measurement but also points out that adjustments
made for growth must also encompass future interest
rate expectations. An attempt to adjust PE for growth
that does not include a discounting function will give
incorrect and sometimes very misleading results.
CHANGES IN GROWTH AND INTEREST
RATE EXPECTATIONS
BET offers a static picture of relative valuations
between stocks. If the forecasts of growth and interest
rates embodied in a BET calculation come true, the
earnings of a stock with lower BET will pay back the
initial price sooner, and the stock will prove to be a
better value than another with higher BET. However, as
markets change, expectations and valuations swing back
and forth, and it is these currents that determine much
or most of intermediate-term investment performance.
We would like to use BET analysis to help understand
how changes in the outlook for growth, discounting
rates, or investors’ attitude toward risk may affect the
performance of our four sample stocks or, more gener-
ally, any stock.
The fact that our BET formula is differentiable
offers the tantalizing prospect of finding the effect on
stock prices of changes in discounting rates, growth
rates, and investor optimism. It also seems that we should
be able to make some generalizations about the relative
performance of growth stocks and value stocks in dif-
ferent market environments. As we shall see, these hopes
are only partially realized.
It is important to re-emphasize that the rate that
determines a stock’s payback period is R, a function both
of future interest rates and future growth. Therefore, if
there is an interplay between these factors, one cannot
generalize about the expected change in stock prices
when interest rates rise or fall.
Even so, the conventional wisdom is consistent on
the topic of interest rates. When rates on the 10-year
Treasury rose recently, the financial press was quick to
offer conclusions: “when rates rise, stocks fall. That’s
because rising rates ripple throughout the economy,
raising costs for companies that want to issue debt, raising
mortgage rates for homeowners and buoying credit card
bills for the typical consumer” (Franck 2018). Or, a bit
more cautiously: “Higher yields for risk-free assets like
142   The Price/Earnings Ratio, Growth, and Interest Rates: The Smartest BET
Treasuries could also cause investors to demand greater
compensation for owning stocks, or push some to switch
out of shares” (Kruger 2018).
This assumption has been ref lected in the financial
literature for decades, in particular through the concept
of equity duration. The duration of a bond is a weighted
average of the time until a payment is received; a version
of it turns out to be the derivative of bond price with
respect to rate, analogous to Equation 3:
dPE ( R − 1) ((1 + BET ) R BET − 1) − ( R BET +1 − R )
=
dR ( R − 1)2
(3)
However, there is a key difference: The bond pay-
ments are fixed, but a corporation’s management may
adapt to changes in the financial environment. A rise in
interest rates may be associated with investment oppor-
tunities that cause growth expectations to rise concomi-
tantly so that today’s stock value is not adversely affected
by rising interest rates.
This possibility was raised (Estep, Hanson, and
Johnson 1983) at a time when inf lation was much
on the mind of investors. The authors proposed that
stocks are affected by interest rate changes via the
mechanism of duration, but they also invoked the con-
cept of a company’s inf lation f lowthrough (i.e., the
change in earnings growth for a given change in the
inf lation rate). The stock of a company with inf lation
f lowthrough of 1.0 would be indifferent to changes
in interest rates if those changes were driven by inf la-
tion expectations.
Leibowitz et al. (1989) extended, formalized, and
improved upon that model. They posited a shift in the
discounting of future receipts as a function of changes
in real interest rates, an equity risk premium, inf lation,
and an inf lation f lowthrough parameter. Still later,
Leibowitz and Kogelman (1994) dealt at length with
the possible changes in a company’s investment oppor-
tunities that might accompany shifts in the interest rate
environment. In the language of BET, we would say
that changes in i may not result in equivalent changes
in investors’ expectations for r. The many compli-
cating factors led Litterman (2005) to conclude that
“a stable structural relationship between stocks and
interest rates does not exist.” Our empirical results,
shown in subsequent sections, support Litterman’s
gloomy conclusion.
September 2019
Exhibit 3
Price Change as a Result of Change in R
6WRFN 3( G3(G5 ∆5 1HZ3( ¨3(3(5
9     
9     
*     
*     
Consider stocks V1, V2, G1, and G2 in Exhibit 3.
The exhibit shows the possible effect of a change in R
as calculated by derivative dPE/dR.
The exhibit makes a rather surprising assertion.
It claims that the prices of all four stocks will respond
nearly the same to a change in R. This also is opposed to
the conventional wisdom, which says that high-growth
stocks with long-deferred payouts (i.e., a long duration)
will be affected much more than low-duration value
stocks. Of course, this is only true if both stocks see
an identical change in expected R, so this theoretical
result cannot be definitively tested. Moreover, when R
changes, it is very likely that valuations change across
the board (i.e., all stocks have a change in BET). As we
shall see, there is a strong differential effect in prices of
growth versus value when all BETs increase or decrease.
A Rising Tide Lifts All Boats…
And a falling tide lowers them onto the reefs below.
A broad market move in either direction can, at least in
theory, create an upward or downward valuation trend
that will affect all equities. This sort of revaluation might
be caused by a change in investors’ attitude toward risk
or, equivalently, a change in their willingness to look at
corporate prospects far in the future. In a time of uncer-
tainty, investors will seek fast payback from cash-f low
sources that are currently visible. In a different moment,
when the path of future growth and expansion seems
smooth, investors may be willing to focus on enterprises
with more distant prospects. In BET jargon, we would
say that sometimes investors will insist on low BET, and
at other times they may be willing to pay up for stocks,
accepting a high value for BET.
This BET contraction and expansion corresponds
to the familiar PE swings that characterize bear and
bull markets. How, specifically, does it affect the price
of individual stocks? The answer is to calculate the
September 2019
sensitivity of stock price to changes in investors’ desired
payback period. The formula is
dPE ( R BET +1 ) ∗ ln( R )
= (4)
dBET ( R − 1)
Again, dividing the result of this equation by PE
gives percentage change in PE. The effect of changes in
BET are shown in Exhibit 4 (rightmost column).
When the market rises because of a market-wide
increase of 1.0 year in the BET that investors are willing
to accept, all four of our sample stocks also rise. This
time, in contrast to Exhibit 3, the gains differ widely
across stocks. Value stocks rise modestly; the biggest gain
is in the high-priced G4, growing at 25% and selling at
55× earnings.
Unfortunately, this proposition defies empirical
testing. Increases or decreases in acceptable BET are
bound to be mixed with changes in growth prospects.
Additionally, both the Growth and Value indexes have
substantial idiosyncratic exposure to macro factors, so
there is no historical period of market advance or decline
that is homogeneous enough to provide a measurement
of the differing impact on low-growth and high-growth
stocks. As noted earlier, the Value index is strongly
weighted toward financial and energy companies, and
the Growth index is currently about 40% technology
companies. These sectors are affected by some common
economic factors, to be sure, but each is exposed to
one or more important economic currents that has little
effect on the others.
Nonetheless, the results of Exhibit 4 seem to com-
port with conventional wisdom: If a period of market
turmoil is expected, investors may naturally want to
shorten the time horizon implicit in their investments,
and the stocks likely to decline least are those like V1.
If, on the other hand, the world is rosy and an extended
period of smooth growth is forecast, investors may feel
confident in stretching out their time horizon, and the
major beneficiaries will be stocks like G4. (Snippets
of computer pseudo-code for computing BET and its
derivatives are found in the online Appendix.)
EMPIRICAL EVIDENCE ABOUT INTEREST
RATES AND EARNINGS GROWTH
Exhibit 5 presents the results of regressions of
changes in interest rates and a proxy for changes in
The Journal of Portfolio Management   143
Exhibit 4
Price Change Due to Changes in BET

6WRFN (36 3ULFH 3( ([SJ ,QW5DWH %(7 G3(G%(7 ¨%(7 1HZ3( ¨3(3(%
9          
9          
*          
*          

Note: EPS = earnings per share; Exp g = expected growth; Int Rate = interest rate.

earnings growth expectations against future quarterly Exhibit 5

total return of the S&P Growth and Value Indexes. Changes in Growth and Value Indexes versus
The time period is November 30, 1999 through August Changes in Earnings Growth and Interest Rates
31, 2018. Interest rates are represented by the 10-year (November 30, 1999–August 31, 2018)
constant maturity Treasury rate, as reported by the
3DQHO$6 3*URZWK,QGH[YV&KDQJHLQ<HDU7UHDVXU\<LHOG
FRED database. DQG6KRUW7HUP(DUQLQJV*URZWK7UHQG LQWHUHVWUDWHFKDQJHLQ
We have no way of getting empirical data for PRQWK0HDUQLQJVJURZWKWUHQGRYHUQLQHPRQWKVHQGLQJLQ0
changes in investors’ growth expectations at points in LQGH[FKDQJH0±0
the past, so we use a rather crude workaround: We assume 6 3*URZWK,QGH[ &RQVW ,QW (DUQ*U
that investors’ outlook for long-term growth will be &RHIILFLHQWV   
altered upward or downward by recent earnings trends. W6WDW   
The number denoted “Earn Gr” is an extrapolation of the 6LJQLILFDQFH   
percentage change of trailing 12-month earnings between (QWLUH3HULRG6LJQLILFDQFH 
the quarter ended six months ago and the quarter ended 3DQHO%6 39DOXH,QGH[YV&KDQJHLQ<HDU7UHDVXU\<LHOG
this month. This turns out to be a satisfactory solution, DQG6KRUW7HUP(DUQLQJV*URZWK7UHQG LQWHUHVWUDWHFKDQJHLQ
as shown by the results of the regressions. PRQWK0HDUQLQJVJURZWKWUHQGRYHUQLQHPRQWKVHQGLQJLQ0
LQGH[FKDQJH0±0
Interest change is the rate at the end of this month
6 39DOXH,QGH[ &RQVW ,QW (DUQ*U
minus the rate at the end of last month. Those variables
are regressed against returns on the relevant index for a &RHIILFLHQWV   
W6WDW   
three-month period beginning one month in the future
6LJQLILFDQFH   
and ending four months from the current date. (QWLUH3HULRG6LJQLILFDQFH 
The first thing we notice is that the coefficient
on interest has the wrong sign: Higher interest rates Source: FRED, Standard & Poor’s, FactSet.
are associated with higher future stock returns. If this
is correct, it seems to imply that investors might asso-
ciate higher interest rates with higher corporate growth rates, and stock prices create extreme values that have an
opportunities. It also contradicts the idea that stocks have outsize effect on any regression that includes data points
an identifiable duration; no matter how duration is cal- from that 2008–2009 period. We might hypothesize that
culated, the concept says that higher interest rates should this is partly responsible for the unexpected relationship
lead to negative stock returns. As we shall see, the effect between interest rates and stock performance.
of interest rates on stocks is not consistent from period Until the end of Q2 2008, earnings had been
to period, and the safest conclusion is that no inference declining but were following a fairly smooth path.
can be drawn one way or the other. The trailing 12-month earnings for the S&P 500 had
It is important to recognize that the period cov- dropped from 66.18 at year-end 2007 to 51.37 but had
ered, November 30, 1999 through August 31, 2018, not yet fallen off a cliff. The PE of the index was 26.
includes the massive earnings recession and bear market In the ensuing months, earnings plummeted, taking
of 2008–2009. The wild swings in earnings, PEs, growth prices with them. Trailing earnings reached a low point

144   The Price/Earnings Ratio, Growth, and Interest Rates: The Smartest BET September 2019
of 6.86 in March 2009, and the PE skyrocketed to 123. Exhibit 6
A steep recovery followed, with quarterly earnings Changes in Growth and Value Indexes versus
again exceeding 50 at the end of February 2010. The Changes in Earnings Growth and Interest Rates
character of the market was significantly altered by this (November 30, 1999–June 30, 2008 and February 28,
harrowing experience and further affected by the super- 2010–August 31, 2018)
easy money regime that followed and continued for the
ensuing decade. &RQVW ,QW (DUQ*U
Because of all this turmoil, the results of regressions 3DQHO$*URZWK,QGH[
that include that period from mid-2008 through early )LUVW6HJPHQW 1RY±-XQ
2010 are overly inf luenced by a few extreme data points. &RHIILFLHQWV ± ± 
As mentioned earlier, changes in long-term expectations 7VWDW ± ± 
6LJQLILFDQFH   
were assumed to be driven by a measurement of short-term
(QWLUH3HULRG6LJQLILFDQFH 
earnings growth. During the recessionary period, the
/DVW6HJPHQW )HE±$XJ
Value index short-term growth series dropped from +14% &RHIILFLHQWV  ± 
to -33%, producing outlier data points that dominated 7VWDW  ± 
regressions. 6LJQLILFDQFH   
After some experimentation and consideration, it (QWLUH3HULRG6LJQLILFDQFH 
seems that the best way to deal with these questions is 3DQHO%9DOXH,QGH[
to provide regressions solved over three time periods. )LUVW6HJPHQW 1RY±-XQ
First, the complete 19.5-year period, including all data, &RHIILFLHQWV ± ± 
as shown in Exhibit 5. Two more time periods are also 7VWDW ± ± 
reported in Exhibit 6: one (referred to as First Segment) 6LJQLILFDQFH   
with the beginning of our dataset at November 30, 1999 (QWLUH3HULRG6LJQLILFDQFH 
and continuing through June 30, 2008, and the other /DVW6HJPHQW )HE±$XJ
&RHIILFLHQWV  ± 
(referred to as Last Segment) from February 28, 2010
7VWDW  ± 
through the end of the dataset at August 31, 2018. 6LJQLILFDQFH   
The subperiod regressions show results that do not (QWLUH3HULRG6LJQLILFDQFH 
quite match the total period. This time, the coefficients
on interest rates have the expected sign, but none is ever Sources: FRED, Standard & Poor’s, FactSet.
close to significance. The significant positive sign of
the interest coefficient in the entire period regression significant in the Last Segment, and in fact that whole
must therefore be due to a strong correspondence during regression is not significant.
the extreme period between mid-2008 and early 2010. It seems likely that this result is attributable to the
In the third and fourth quarters of 2008, the 10-year fact mentioned previously, that modeling Earn Gr by
Treasury rate dropped from 4.10% to 2.42%, and the simple extrapolation gives an inadequate picture of what
total return of the value index was -33.1%. This outlier investors were thinking about growth prospects for the
in the data, which is excluded in the subperiod regres- stocks in the Value index in 2010–2018. During the Last
sions, turned out to be enough to create the appearance Segment, major macro inf luences affected Value stocks:
of a significant positive coefficient on interest rates for the Fed’s massive injection of liquidity and artificially
the total period. In any event, it appears to be true that low interest rates and the gyrations in oil prices that
there is no consistent duration effect; as mentioned ear- sent oil stocks into a bear market, followed by an even-
lier, changes in i do not seem to result in equivalent tual recovery. The two largest components of the Value
changes in investors’ forecasts of r. index are financial and energy stocks; investors surely
For the Growth index, the coefficients on Earn Gr judged the growth prospects of both these sectors much
are even more significant over the subperiods than for more by the news of the day about Fed policy and oil
the longer span, and the coefficient on Earn Gr is highly prices than by extrapolating from history.
significant for the Value in the First Segment. However,
for the Value index, the coefficient on Earn Gr is not

September 2019 The Journal of Portfolio Management   145

CONCLUSION
The principal focus of this article is to explicate
the correct relationship between PE and expectations for
future interest rates and earnings growth. The ratio of
price to earnings provides a measurement, denominated
in years, of the time it would take for a company to earn
an amount equal to today’s stock price. However, the
simple PE assumes that earnings in the future are the
same as today’s and makes no provision for discounting
earnings to be received years from now. BET cor-
rectly embodies both expected growth and expected
discounting rates and gives results that will often vary
substantially both from a simple PE and from the heu-
ristic PEG ratio. Therefore, BET provides a much more
valid basis for comparisons among stocks. In assessing
the valuations of three stocks, one might find that stock
A has the lowest PE and stock B has the lowest PEG,
whereas stock C has the lowest BET and is therefore
objectively the most attractive.
We present empirical analysis of the actual rela-
tionships between these quantities and observed stock
returns. That analysis shows that, for the periods tested,
the relationship of stock prices to changes in interest rates
does not agree with the conventional wisdom or with
some of the financial literature; the relationship appears
to be random. Regressions give differing results over
different time periods, and the coefficients are unstable
and usually far from significance.
On the other hand, even a primitive model of
earnings growth expectations proves to have a strong
positive relationship with subsequent stock returns. Our
results substantiate the proposition that an attempt to
place a value on stocks today must incorporate an assess-
ment of their growth prospects. And how best to do
that? BET on it.
ACKNOWLEDGMENT
The author would like to thank Joe Tannehill for
valuable input and comments.
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Value and Risk in Common Stocks.” The Journal of Portfolio
Management 9 (4): 5–13.
146   The Price/Earnings Ratio, Growth, and Interest Rates: The Smartest BET
Farina, M. A Beginner’s Guide to Successful Investing in the Stock
Market. Investors Press, 1969.
Franck, T. “Here’s the Number Everyone in the Financial
Markets is Obsessing about and Why.” CNBC, 2018, https://
www.cnbc.com/2018/10/05/why-wall-street-cares-so-
much-about-10-year-treasury-rates.html.
Kruger, D. “Bond Yields Reach New Highs On Growth
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Leibowitz, M., and S. Kogelman. “Franchise Value and the
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Leibowitz, M., E. Sorenson, R. Arnott, and N. Hanson. 1989.
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To order reprints of this article, please contact David Rowe at
d.rowe@pageantmedia.com or 646-891-2157.
ADDITIONAL READING
Understanding the PEG Ratio
M ark A. T rombley
The Journal of Investing
https://joi.pm-research.com/content/17/1/22
ABSTRACT: The price-earnings-to-growth, or PEG, ratio is
widely used by both individual investors and professional portfolio
managers. This article explores the relationship between the PEG
ratio and its determinants. The main conclusions are that (1) higher
PEG ratios are consistent with correct valuation for firms with rela-
September 2019
tively low growth, for firms with more persistent high growth, and
for firms with low cost of capital, and (2) PEG ratios frequently
should exceed the conventional 1.0 benchmark for correctly valued
firms, especially those with low cost of capital. The article recom-
mends against using PEG as a tool to choose among different types
of firms and concludes that the best use of PEG is for within-industry
screening when firms are likely to have similar cost of capital and
similar growth prospects.

Cash Flows, Asset Values, and Investment Returns

P reston W. E step
The Journal of Portfolio Management
https://jpm.pm-research.com/content/29/3/17
ABSTRACT: Most methods for forecasting expected returns of
stocks are based on earnings. As analysts have justifiably become
somewhat wary of earnings reports, they are increasingly interested
in developing valuation models that are based on sources and uses of
cash. There should be some way to analyze financial statements to
make the two approaches give identical results, since the underlying
economics are the same. The author provides a convenient formula
that states the return expected by an investor in terms of the cash
flow/price ratio, some fraction of the growth rate, and changes in
valuation (i.e., PE expansion or contraction). The fraction of growth
that ends up in the shareholder’s pocket will depend on the size of
the company’s fixed asset accounts, and whether growth is financed
by equity sale or debt issuance.

September 2019 The Journal of Portfolio Management   147

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