L7 - Fundamental Principles and Earnings Multiple_2001s2

# And its impact on pe via the payout ratio a rise in

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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.