Financial Accounting Blog

Sunday, January 25, 2004

PE Ratio. The New York Times reports that a study has been conducted concluding that high P/E companies cannot possibly grow as quickly as they need to in order to justify thier high valuations.

As part of their research, the professors checked a database of all publicly traded domestic companies for those whose earnings at any time from 1951 to 1998 grew at more than the median annual rate for five consecutive years. That may seem a modest prerequisite, since that median over those 48 years was around 6 percent. But very few companies met that condition, and those that did were rarely those that investors had valued at the high end of the spectrum. The professors concluded that very high P/E ratios were hardly ever justified.

One company that has a P/E ratio around 102 based on earnings for 2003 is Ebay. Ebay is currently trading at $69.35 and if we assume that it's stock price grows just 8% annualized over the next 5 years to $102, its EPS would have to grow 30% annually to justify today's valuation.