One way to make sense of the P/E ratio of a company is:
P/E ratio = 1 / (Returns - Growth), whereGrowth is the expected growth in the company's earningsReturns is the expected returns by investors for taking on the risk of investing in the company. It is directly related to the perceived risk in the company's earnings. The higher the perceived risk, the more the expected returns
In other words, the P/E ratio is the reciprocal of difference between expected Returns and Growth.
Expected Earnings Growth
Input #1 = Returns,
Input#2 = Growth
Calculated P/E ratio
One lens to understand what changes the stock price, P, for a company focuses on 3 things:
1. Change in market's expectation for future Earnings Risk, R
2. Change in market's expectation for future Earnings Growth, G
3. Change in market's expectation for future fraction of earnings that should be returned as cash
It does NOT change with one-time charges that are not likely to have sustained impact on earnings over time, or accounting jugglery!
Below we discuss some interesting cases