Financial Analysts Journal 01 Jan 1995 Volume 51 Issue 1
A Theory of Price–Earnings Ratios
In theory, true investment value cannot change; it is always determined by future dividends and interest rates. But this ideal cannot be attained, and investors must find a way of substituting an operational concept that is practical and works. This article provides a blueprint of the operating mechanism of the price-to-earnings ratio in the valuation process. It establishes the view that capitalized earning power is an operational expression of value in the stock market, and it derives the relationships among current earnings, earning power, and the P/E. To the extent that stock prices depend on value, the deviations of current earnings from earning power determine the extent of needed compensation or discount in the price. The article compares actual historical P/Es with hypothetical P/Es—the reciprocal of the deviations of current earnings from estimated earning power—and discusses deviations of history from theory and what the deviations reveal about investor opinions of prices and future earning power in certain times. A primary challenge in using the method is the choice of a moving average for capitalized earning power.
About the Author(s)
Nicholas Molodovsky was the second editor of the Financial Analyst Journal. He was most well-known for changing the direction of the profession with his blueprint for using the price-to earnings ratio in the valuation process. The Outstanding Contribution to Investment Research Award was created in his honor to recognize individuals with similar contributions and was first awarded in 1968.