Thread by @supercimomo

1/
 
What should the “intrinsic P/E ratio” be for an “average US company” in today’s market?

Is it possible to find this out?
 
Yes, it is roughly 16.92.

Let’s do some math.

#stocks #investing #ValueInvesting

2/
 
First, let’s define what is an “average US company”?

We assume this is a US company that is mature.
 
Its cash flows grow at a steady rate.
 
It has market average risk: beta = 1.
 
And it earns no excess returns: Return on Equity (ROE) = Cost of Equity.

3/
 
For such a company, we can use the Gordon Growth Model to compute its intrinsic value:

P = FCFE1 / (r – g)

where FCFE1 is next year’s cash flow available to equity owners (or potential dividend), r is the cost of equity, and g is the steady growth rate.

4/
 
Potential dividend = earning – necessary reinvestment:
 
P = E(1 – reinvestment rate) / (r – g)

And growth is a product of how much we reinvest and how well we reinvest:
 
g = reinvestment rate * ROE

5/
 
Therefore:
 
P = E(1 – g/ROE) / r(1 – g/r)
 
Since ROE = r, we have:

P = E(1 – g/r) / r(1 – g/r)
 
Which gives us:
 
P/E = 1/r

6/
 
r = risk free rate + equity risk premium
 
Today, we have:
risk free rate = 10yr t-bond yield = 1.65%
Implied equity risk premium = 4.26%
 
So:


P/E = 1 / (0.0165 + 0.0426) = 16.92
 
An “average US company” in today’s market should have an intrinsic P/E ratio of 16.92.

7/
 
Now, no company is exactly “average”. But from this exercise we can see how different factors impact the intrinsic P/E:
 
A company with high ROE demands higher P/E.
A company with high growth demands higher P/E.
A company with high risk demands lower P/E.
etc.

8/
 
Also, we can see how macro factors drive the intrinsic P/E:

Rising 10yr t-bond yield causes P/E to drop.
Market anxiety about a reversal of the FED liquidity paradigm may call for higher ERP, and causes P/E to drop.
etc.

9/

Thanks for reading thus far!

If people find this type of content interesting/useful, I’ll do more of these in the future.
 
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