Joelsol,
To truly understand P/E ratios you must examine the factors that fundamentally drive them. To do this let us start with the basic pricing formula for commong stocks
P0 = FCF1 / (k -g)
where;
P0 = Price of stock today
FCF1 = Free cash flow next year
k = required rate of return
g = perpetual growth rate in FCF
This formula tells us that the value of the stock today is equal to the present value of all its future expected cash flows. It assumes FCF grows at a steady constant rate, g, foreever and that the rate of return investors require maintains constant forever. Obviously most stocks do not exhibit this type of behavior but by making these over simplifying assumptions we can more easily evalutate P/E ratios. Besides we can always adjust the forumula to account for differences in growth. The important thing to remember is that the fundamentals remain the same either way. First, let us seprate FCF into its two components. FCF is defined as cash flow after reinvestment needs or after tax operating profit after tax less reinvestment Therefore,
FCF = Operating Profit - Reinvestment
Furthermore, we can express the reinvestment as a percentage of operating profit. Doing so converts the equation into the following:
FCF = Operating Profit - (Operating Profit*IR)
Or more simply
FCF = Operating Profit*(1-IR)
IR is the reinvestment rate, which we can also disect into its components. To do so we start with this formula.
g = IR*ROIC
This formula tells us that the growth in operating profit is equal to the reinvement rate (IR) multiplied by the return on invested capital (ROIC). Rearranging this formula and solving for IR we get:
IR = g/ROIC
Thus, FCF can be written as:
FCF = Operating Profit*(1-(g/ROIC))
Taking this and plugging it into the original formula we get
Price = (Operating Profit*(1-(g/ROIC)))/(k-g)
Finally, to get to the P/E ratio divide both sides by earnings. Assuming earnings equals operating profit (which is normally the case unless a firm has non-operating income) operating profit will cancle out. Therefore, we discover that the P/E ratio is equal to the following:
P/E = (1-(g/ROIC))/(k-g)
Furthermore, if we growth in the denominator with the growth equation mentioned above we get:
P/E = (1-(g/ROIC))/(k-ROIC*IR)
Therefore, we see that P/E ratios are driven by four factors: return on invested capital (ROIC), growth (g), the reinvestment rate (IR), and the required rate of return or risk (k). Firms that have high returns on invested capital, high growth, and low risk will have higher P/E ratios than firms with low returns on invested capital, low growth, and high risk. Howwever, let us evaluatate each of these factors a little more closely.
ROIC - Do firms with higher returns on invested capital have higher P/E ratios?
Ceterus paribas firms with higher returns on invested capital will have higher P/E ratios than firms with lower returns on invested capital. This is the case because higher returns on invested capital result in higher growth, larger cash flow, and helps close the spread between the ROIC and cost of capital. Moreover, if a firm can increase its return on invested capital it should always expect a corresponding rise it is P/E ratio.
K - Do firms with lower levels of risk command higher P/E ratios than firms with higher levels of risk.
Yes, firms with lower levels of risk will always command higher P/E ratios than firms with high levels of risk. Thus,
g - Do firms with higher levels of growth command higher P/E ratios than firms with lower levels of growth.
Not necessarily. Growth will only increase the P/E ratio when the return on invested capital is greater than the cost of capital, or risk (k). If a firm attempts to increase its growth rate when its return on invested capital is lower than the cost of capital (k) it will actually lower its P/E ratio. Firms can only increase their P/E ratios through growth when the ROIC is greater than the cost of capital
IR - Do firms with high reinvestment rates command higher P/E ratios than firms with lower reinvestment rates?
Again this depends. If a firm is earning returns on invested capitail in excess of capital costs than reinvesting more money now will cause the P/E ratio to increase. However, if returns on invested capital are below the cost of capital then reinvesting more money will actually lower P/E ratios.
With this information let us now answer your original questions.
Is a high P/E good or bad?
This depends. A high P/E ratio may simply be a reflection of a company's fundamentals. For example, if a stock has high growth, high returns on invested capital, and low risk than it will command a high P/E ratio. Thus, in this case it would not be a bad thing but just a reflection of company dynamics. On the other hand if the P/E ratio is high but the fundamentals do not support it than it may imply that the stockis overvalued which is a bad thing.
If the P/E ratio is high does it mean the stock is overprice or underprice?
Again this depends on the company's fundamentals. A high or low P/E ratio doesn't really tell us much by itself. It is only informative when we examine it in the context of what drives the multiple. So if a P/E is high it may mean that the firm has, say, low risk, or it could mean the stock is overvalued. Always think in the context of the factors that drive the multiple to determine valuation.
If the P/E ratio is high do I buy or sell stocks?
For one you shouldn't by any stock simply because its P/E ratio is high or low. However, if you are using the P/E multiple as one measure of value than your objective is to find stocks trading at P/E multiple lower than their implied multiples. In other words buy stocks whose P/E multiples are lower than what they should be given the company's fundamentals.
Angell