and its impact on PE via the payout ratio: A rise in ROE can support a rise in payout for
any given value of earnings growth as g = (1
‐
payout
↑
) × ROE
↑
PE Ratio for S&P 500: 1960-2004
0
5
10
15
20
25
30
35
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
PE Ratio
Average over period = 16.82

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FINS3641 SAV
Week 8: Fundamental Principles and Earnings Multiples
18
c)
Quantifying the time series relationship between PE and its fundamentals using US data 1960
‐
2004
E/P = 2.07% + 0.746 10
‐
yr T Bond Rate
‐
0.323 (10
‐
yr T Bond Rate
‐
6
‐
mth T Bill Rate)
R
2
= 0.51
(2.31)
(6.51)
(
‐
1.28)
Every 1% increase in the T bond rate increases the earnings yield by 0.75% (confirming the inverse
relationship between PE and r
f
since earnings yield is 1÷PE ratio).
Every 1% increase in the difference between long term and short term rates decreases the
earnings yield by 0.32% (confirming the positive relationship between PE and economic growth the
yield spread is a proxy for economic growth).
d)
Given the relationship and that 10
‐
yr T Bond Rate was 4% and 6
‐
mth T Bill Rate was 2.5% in Feb 2005,
the model would suggest that
E/P
Feb, 2005
= 2.07% + 0.746 (4)
‐
0.323 (4
‐
2.5) = 4.57%
PE
Feb, 2005
= 1/.0457 = 21.88
e)
The actual PE ratio in February 2005 was 21. This would suggest that the market was fairly priced,
assuming that the historical relationship between PE ratios and interest rates continues to hold.