P/E Multiples vs. Inflation, Interest Rates, Volatility, and Leverage

CFA Level II Portfolio Management
#1

  1. Why are high P/E ratios likely associated with a decrease in inflation expectations, and a decrease in real interest rates?

  2. Why P/FFO (assuming this also applies to P/E ratios) are inversely related to volatility and leverage?

#2

The P/E ratio reflects the extent to which you are willing to pay for the company’s earnings.

When inflation (or expected inflation) and real interest rates are low, you are willing to pay more for the earnings due to the modest (expected) inflation and lower borrowing cost which implies a greater opportunity for higher real earnings.

And when there’s a high level of leverage and volatility, you are willing to pay less for the earnings because of the uncertainty.

#3

I see, can it also be understood as a lower discount rate causing a higher price valuation?

Similar to above, higher leverage and volatility imply higher risk, i.e., higher discount rate and a lower price valuation?

#4

Assume the only growth a company has is inflation

Price = D(1) / ( r - g)
split r - discount rate = iinto two parts real rate and inflation
g is also inflation

So we have
Price = D(1) / (real rate + inflation(m) - inflation(c) )

We can see the real rate has a direct effect on valuation, we could say in tha “real” rate we have an element for inflation risk if our rane of inflation is 2 -10% that is more of a risk factor than 2.2 -2.2% and so we have a higher inflation risk premium.

Inflation - we have two elements to think about
There is inflation in the economy as a whole effecting the returns required - inflation (m)
And the inlfation the company gets in its pricing profits(c)

There is risk here too. Can the company pass on market inflation. Will it be able to pass on the costs increase [assume workers want rises of market inflation) to customers? Areas with poor compeition and regulation (broadbrand prviders in the UK putting CPI+ terms in contracts) or very compeitive (restaurants and pubs). This is inllation passthrough risk. This is much more of an issue if inflation is 12% verus 2%.

The P/E people are willing to pay is inversely related to these risk.

P/AFFO - volatility = risk - lower multiples.
Debt (can be more complex) as you get better ROEs but crudly. More debt = more volaitility = more risk.

1 Like
#5

Thank you for the thorough explanation.

#6

Yes, of course. These factors are part of discount rate.

1 Like
#7

Thanks!