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Lesson 4 of 9 · 14 min

P/E in depth: earnings yield, PVGO and normalized earnings

The P/E tells you how much of a price is a bet on future growth; its justified value rises with growth and falls with risk, and it is only useful when the earnings in the denominator are positive, recurring and adjusted for the business cycle.

In short

  • Earnings yield = E/P. A no-growth firm is worth EPS1/re\text{EPS}_1/r_e; any price above that is the present value of growth opportunities (PVGO).
  • PVGO/P=1−(EPS1/P)/re\text{PVGO}/P = 1 - (\text{EPS}_1/P)/r_e. Negative PVGO suggests reinvestment destroys value.
  • Justified trailing P/E = payout × (1 + g) / (rer_e − g): up with g, down with rer_e.
  • Use core earnings: strip out non-recurring items. P/E is not meaningful when EPS is zero, negative or tiny.
  • For cyclicals use normalized EPS: the average EPS over a full cycle, or average ROE × current book value per share (better when the company's size has changed). Consider diluted EPS.

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P/E in depth: earnings yield, PVGO and normalized earnings · Relative Value Equity Valuation Approaches