Factors that impact P/E Growth

[rexthedog]

Inflation / ERP’s / required return / earnings growth.

1. I understand required return - if R increases, you discount CF at higher rate. Lower price, therefore Lower P/E

2. Earnings growth increases, CF increase. price increase. P/E Increase

How does ERP and inflation impact the P/E growth? Let’s say both are increasing. (Is this intuition correct: higher inflation = higher prices = higher P/E)

And what about the ERP what is the intuition here.

Thanks

[Black8Mamba23]

Maybe someone else can cite something straight out of the curriculum’s readings on this, but I’ll take a shot.

Increasing inflation (inflation in goods and services, not asset prices) = rising nominal interest rates, which increases discount rates, which reduces PV of cash flows, in turn reducing P/Es.

Increasing ERP = increasing discount rates (i.e.,think all the models used to est. required return on equity like CAPM, FFM, PSM, where req. return on equity is a positive function of ERP), which reduces PV of cash flows, in turn reducing P/Es.

[rexthedog]

Cheers Mamba. The ERP one makes sense when you put it in the CAPM function

[Frankliving]

@rexthedog

Inflation / ERP’s / required return / earnings growth.

1. I understand required return - if R increases, you discount CF at higher rate. Lower price, therefore Lower P/E

Correct

2. Earnings growth increases, CF increase. price increase. P/E Increase

Correct

How does ERP and inflation impact the P/E growth? Let’s say both are increasing. (Is this intuition correct: higher inflation = higher prices = higher P/E)

The intuition is earnings are an increasing function of growth and a decreasing function of ERP and the required rate of return. So high ERP or required return must lower earnings and hence lower P/E because the denominator is getting smaller.

The higher ERP the higher the required rate of return using CAPM remember required rate of return = rf + beta (ERP) which is your discount rate.

By default Higher inflation erodes value hence it also erodes earnings. High inflation does not mean higher prices by default.

It depends on the pass through rate the firm. In other words how elastic is the price of the goods to an increase in price? If the price elasticity is very high then the firm will have very low pass through rate because a small increase in price (even if only in line with inflation) will mean a drop in volume as customers will look for substitutes. The outcome of this will be again lower earnings and lower price. Because price is an increasing function of earnings.

For the exam remember:

Firm A and Firm be are comparable except A is in a country with 5% inflation and B is in a country with 3%. The amount of inflation alone does not tell us which firm will have lower earnings. We must consider the pass through rates first. E.g A although in a high inflation country could have very high pass through rates and hence pass through most of the inflation impact. Whereas B although in a low inflation country could have very low pass through rates and hence have a larger decrease than A.

And what about the ERP what is the intuition here.

Thanks

[rexthedog]

Thanks Frankk!