Set out the fundamentals that drive dividend yield and alternative price multiples
The idea
The fundamental drivers of each multiple come from the constant-growth model. Justified P/E rises with the payout ratio and with growth, and falls as the required return rises. Justified P/B equals (ROE − g) ÷ (r − g), so it rises with ROE relative to the required return and exceeds one only when ROE exceeds r. Justified P/S equals profit margin × payout × (1 + g) ÷ (r − g), so a higher margin lifts it. Dividend yield, D1 ÷ P0, equals r − g, so it rises with the required return and falls as expected growth rises. The trap is assuming a higher payout always raises the P/E, forgetting that paying out more leaves less to reinvest and so lowers growth.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →More in Market-Based Valuation: Price and Enterprise Value Multiples
- Contrast comparables with forecasted fundamentals as ways of applying price multiples when valuing, and set out the economic logic behind each
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- Set out why one might value a stock with dividend yield or alternative price multiples and what can go wrong
- Work out dividend yield and alternative price multiples and explain what they mean
- Work out underlying earnings and explain them, set out ways to normalise earnings per share (EPS), and compute normalised EPS
- Explain earnings yield (E/P) and argue for its use
- Use a cross-sectional regression on fundamentals to predict a P/E, explain the result, and explain where such regressions fall short
- From forecasted fundamentals, work out a stock's justified price-to-earnings (P/E), price-to-book (P/B) and price-to-sales (P/S) ratios and explain them
- Work out the PEG (P/E-to-growth) ratio, explain what it means and how it is used in relative valuation
- Work out terminal value for a DCF (discounted cash flow) model with several stages from price multiples and explain this use
- Judge from comparisons of multiples whether a stock is priced too high, too low or fairly
- Assess a stock with comparables and explain why fundamentals matter when applying that method
- Explain the various cash flow definitions used in multiples of price and of enterprise value (EV) and where each falls short
- Work out EV multiples, explain what they mean and assess how useful EV/EBITDA is
- Explain why valuation comparisons across borders can differ
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- Explain how the median, arithmetic mean, harmonic mean and weighted harmonic mean summarise the typical level of a set of multiples