{"id":20066,"date":"2021-08-20T20:22:36","date_gmt":"2021-08-20T20:22:36","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=20066"},"modified":"2024-04-05T11:19:19","modified_gmt":"2024-04-05T11:19:19","slug":"calculating-and-interpreting-a-predicted-p-e","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/calculating-and-interpreting-a-predicted-p-e\/","title":{"rendered":"Calculating and Interpreting a Predicted P\/E"},"content":{"rendered":"<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/0kMmbenpFuo\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><span data-mce-type=\"bookmark\" style=\"display: inline-block; width: 0px; overflow: hidden; line-height: 0;\" class=\"mce_SELRES_start\">\ufeff<\/span><span data-mce-type=\"bookmark\" style=\"display: inline-block; width: 0px; overflow: hidden; line-height: 0;\" class=\"mce_SELRES_start\">\ufeff<\/span><\/iframe><\/p>\r\n\r\n<p>A predicted P\/E is estimated from the cross-sectional regressions of P\/E on the fundamentals that are considered to determine investment value, e.g., the growth rate of earnings and payout ratio.<\/p>\r\n<h3>Example: Calculating a Predicted P\/E<\/h3>\r\n<p>Consider a firm with a beta of 0.8, a dividend payout ratio of 0.40, and an earnings growth rate of 0.09. The estimated regression for a group of stocks in the same industry is:<\/p>\r\n<p>$$\\text{Predicted P\/E} = 11.12 + (2.15\\times\\text{DPR}) \u2013 (0.15\\times\\text{Beta}) + (12.43\\times\\text{EGR})$$<\/p>\r\n<p>Where DPR is the dividend payout ratio, and EGR is the five-year earnings growth rate.<\/p>\r\n<p>Based on this cross-sectional regression, the company\u2019s predicted P\/E is 12.979.<\/p>\r\n<p>$$ \\begin{align*} \\text{Predicted P\u2044E}  &#038; =11.12+(2.15 \\times 0.40)-(0.15 \\times 0.8)+(12.43 \\times 0.09) \\\\ &#038; = 12.979 \\end{align*} $$<\/p>\r\n<p>If the stock\u2019s actual trailing P\/E is 17, the stock is overvalued as it is selling at a higher multiple than is justified P\/E by its fundamentals.<\/p>\r\n<p>The predicted P\/E has three limitations:<\/p>\r\n<ol style=\"list-style-type: lower-roman;\">\r\n\t<li>It summarizes valuation relationships only for the specific stock over a particular period. The relationship may have poor predictive quality when applied to other stocks or outside the sample period.<\/li>\r\n\t<li>The relationship between company fundamentals and P\/E changes over time, diminishing the model&#8217;s predictive power.<\/li>\r\n\t<li>Such regressions tend to suffer from multicollinearity making it difficult to interpret individual regression coefficients.<\/li>\r\n<\/ol>\r\n<blockquote>\r\n<h2>Question<\/h2>\r\n<p>A company has a beta of 0.6, a dividend payout ratio of 0.30, and an earnings growth rate of 0.07. The predicted P\/E is <em>closest to:<\/em><\/p>\r\n<ol style=\"list-style-type: upper-alpha;\">\r\n\t<li>12.62.<\/li>\r\n\t<li>14.50.<\/li>\r\n\t<li>16.32.<\/li>\r\n<\/ol>\r\n<h4>Solution<\/h4>\r\n<p><strong>The correct answer is A.<\/strong><\/p>\r\n<p>$$\\begin{align*}\\text{Predicted P\/E}&amp; = 11.12 + (2.15\\times\\text{DPR}) \u2013 (0.15\\times\\text{Beta}) \\\\ &#038; + (12.43\\times\\text{EGR})\\\\&amp;= 11.12 + (2.15 \\times 0.30)\u2013 (0.15 \\times 0.6)+ (12.43 \\times 0.07)\\\\&amp;=12.62\\end{align*}$$<\/p>\r\n<\/blockquote>\r\n<p>Reading 25: Market-Based Valuation: Price and Enterprise Value Multiples<\/p>\r\n<p><em>LOS 25 (i) Calculate and interpret a predicted P\/E, given a cross-sectional regression on fundamentals, and explain limitations to the cross-sectional regression methodology.<\/em><\/p>\r\n","protected":false},"excerpt":{"rendered":"<p>\ufeff\ufeff A predicted P\/E is estimated from the cross-sectional regressions of P\/E on the fundamentals that are considered to determine investment value, e.g., the growth rate of earnings and payout ratio. Example: Calculating a Predicted P\/E Consider a firm with&#8230;<\/p>\n","protected":false},"author":5,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[102,401],"tags":[483,216,402,474],"class_list":["post-20066","post","type-post","status-publish","format-standard","hentry","category-cfa-level-2","category-equity-valuation","tag-calculating-and-interpreting-a-predicted-p-e","tag-cfa-level-2","tag-equity-valuation","tag-reading-29-market-based-valuation","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v27.4 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Calculating and Interpreting a Predicted P\/E - CFA, FRM, and Actuarial Exams Study Notes<\/title>\n<meta name=\"description\" content=\"Learn the limitations of predicted P\/E calculations, including predictive quality, changes over time, and multicollinearity issues.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/calculating-and-interpreting-a-predicted-p-e\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Calculating and Interpreting a Predicted P\/E - 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