The formula for the leading P/E is P0/E1= D1/E1/Ke-g
As per this formula if our cost of capital increases (a negative thing), it would increase our denominator and hence reduce our leading P/E (a positive thing)
Our growth increases (a positive thing) and denominator decreases, this leads to a higher leading P/E (a negative thing)
I don’t quite get this. I suspect my doubt is a bit silly and I am missing out on thinking about something quite logical, that I already know, but I’d still appreciate some clarification. Thank you!
To really understand the logic, I think the best approach is to schedule out a stream of cash flows and discount it back at a cost of capital. Here is an example:
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1 |
2 |
3 |
4 |
5 |
6 |
7 |
8 |
9 |
10 |
| Cash Flow |
1,000.00 |
1,025.00 |
1,050.63 |
1,076.89 |
1,103.81 |
1,131.41 |
1,159.69 |
1,188.69 |
1,218.40 |
1,248.86 |
| Discount Factor |
0.900 |
0.81 |
0.73 |
0.66 |
0.59 |
0.53 |
0.48 |
0.43 |
0.39 |
0.35 |
| Discounted Cash Flow |
900.00 |
830.25 |
765.91 |
706.55 |
651.79 |
601.28 |
554.68 |
511.69 |
472.03 |
435.45 |
| Present Value |
6,429.62 |
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| Growth |
2.5% |
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| CoC |
10.0% |
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If you take the same cash flow stream and increase the growth rate to 5%, the value goes up:
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1 |
2 |
3 |
4 |
5 |
6 |
7 |
8 |
9 |
10 |
| Cash Flow |
1,000.00 |
1,050.00 |
1,102.50 |
1,157.63 |
1,215.51 |
1,276.28 |
1,340.10 |
1,407.10 |
1,477.46 |
1,551.33 |
| Discount Factor |
0.900 |
0.81 |
0.73 |
0.66 |
0.59 |
0.53 |
0.48 |
0.43 |
0.39 |
0.35 |
| Discounted Cash Flow |
900.00 |
850.50 |
803.72 |
759.52 |
717.74 |
678.27 |
640.96 |
605.71 |
572.40 |
540.91 |
| Present Value |
7,069.74 |
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| Growth |
5.0% |
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| CoC |
10.0% |
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Or, if you increase the cost of capital to 15% the value goes down:
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1 |
2 |
3 |
4 |
5 |
6 |
7 |
8 |
9 |
10 |
| Cash Flow |
1,000.00 |
1,025.00 |
1,050.63 |
1,076.89 |
1,103.81 |
1,131.41 |
1,159.69 |
1,188.69 |
1,218.40 |
1,248.86 |
| Discount Factor |
0.850 |
0.72 |
0.61 |
0.52 |
0.44 |
0.38 |
0.32 |
0.27 |
0.23 |
0.20 |
| Discounted Cash Flow |
850.00 |
740.56 |
645.22 |
562.14 |
489.77 |
426.71 |
371.77 |
323.91 |
282.20 |
245.87 |
| Present Value |
4,938.15 |
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| Growth |
2.5% |
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| CoC |
15.0% |
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Build your own model in Excel to experiment with these variables. I think that will help you understand the logic better.
Thank you so much for the response. I appreciate it, and yes, I have created DCF models such as the one shown as well!
Think of it this way -
Increase in Ke means the company is more risky which means investor shall discount it heavily and this leads to lower MPS and lower PE.
Increase in growth means greater cash inflows for the company resulting into greater dividends to the investor(Growth rate is assumed for both earning and dividends), and with greater cashflow higher the MPS and higher the PE.