How do you know if the P/E range so far, is reasonable? Perhaps the range so far is in the top part of what will play out in the future?
- To ensure that the P/E range (lowest P/E to highest P/E) is reasonable, you need to find a company that has a long history and experienced booms & busts before, as opposed to a brand new IPO where we have not yet seen the full cycle of P/E fluctuations (see more details in the next bullet point). It is also good to plot the historical P/E range to see how the range has been shifting w.r.t market conditions.
How will the P/E range be affected by other factors in the future? by interest rates? inflation? etc?
- The P/E range is an output of valuation, hence it will only be affected by:
- Factors affecting Earnings (e.g. inflation)
- Factors affecting the Discount Factors (e.g. interest rates)
- Interest rates: The interest rates will directly affect the P/E range as they directly impact the valuation of cash flows. If the range of interest rate movements deviate significantly from historicals, then the P/E range needs to be adjusted correspondingly. From 1990 – June 2007, the Fed Funds rate ranged from 1% – 8.25%. From 1955 – 1990, the Fed Funds rate ranged from 0.75% – 19% (see time series from Economagic). I think it is a reasonable assumption that the future Fed Funds rate will range from 1% – 8.25%, and hence to use the P/E range from 1990 – June 2007. [Note: if you only use 10 years of historical data, i.e. 1997 – 2007, the Fed Funds range is only 1% – 6.5%. Hence using from 1990 – 2007 will be more conservative.]
- Inflation: Inflation should not affect the P/E range as any compounded increase in the earnings of the company due to inflation, will be counteracted by the nominal interest rate used in discounting (which includes inflation effects and which will also be compounded).
What other factors affect the comparability of P/Es across different time periods?
- I read somewhere about a paper – “Five Factors Distorting P/E Comparisons Over Time” by Art Laffer and Marc Miles that talks about the need to adjust P/Es for interest rates, changes in GAAP, changes in marginal tax rate, etc. (total of 5 factors). I have not been successful in obtaining a copy of the paper, so if anyone who happens to read this and is able to obtain a copy, please contact me!🙂