Most investors are familiar with PE ratios as a basic approach to valuing stocks. But what drives PE ratios? Why do some stocks trade at high PEs while others trade at low PEs?

Conventional wisdom holds that PE ratios are a function of potential growth. High growth companies should have high PEs and low growth companies should have low PEs. In his book, One Up On Wall Street, legendary mutual fund manager Peter Lynch popularized a way to codify this relationship using the PEG Ratio (PE ratio divided by earnings growth rate). Lynch argued that a stock is fairly valued when its PE ratio is equal to its growth rate (ie. the PEG Ratio is equal to 1.0).

Lynch had a brilliant track record, but it seems hard to believe that he followed his own advice on the PEG Ratio closely. If a 1.0 PEG ratio is fair value, the US stock market, with its long-term average earnings growth rate of around 5% should command a PE ratio of 5x, about a third of the actually observed average valuation. On the other hand, very few companies have ever grown earnings by 20%+ for more than a decade, yet many companies trade at PE ratios of over 20x and sustain this valuation level over long periods of time.

So while growth potential clearly influences PE ratios (you don’t need an Excel spreadsheet to tell you a quickly growing company is worth more than a slow-growing company, all else equal), something else is a meaningful driver of PE ratios.

At Ensemble Capital, we believe that a company’s long-term sustainable return on invested capital is a much larger driver of valuation ratios (such as the PE ratio) than growth rates, despite most investors (and particularly Wall Street research) focusing their attention on growth potential and rarely discussing returns on capital.

The most simplified valuation model is the Gordon Growth model, which can be used to accurately value any steady, predictable stream of cash flows.

P = price, D1 = distributable cash*, r = required rate of return, g = growth

The model says that a company generating $1.00 of distributable cash and growing at 5% a year will be worth $25.00 if investors demand a 9%** rate of return to own the stock (1.00/(.09-.05)=25.00). A company growing at just 3% a year would be worth $16.67 (1.00/(.09-.03)=$16.67). In other words, the company growing 5% a year is worth 25x distributable cash flow while the one growing 3% a year is worth 16.7x distributable cash flow.

But note that these multiples are not price to earnings ratios, but price to distributable cash flow ratios. This is where return on invested capital comes in. See this post on the details of ROIC, but the basic message is that the higher a company’s ROIC, the less cash flow they need to reinvest to achieve a given level of growth.

Historically, the average US company has generated ROIC of about 10%. In order to grow 5%, a company with a 10% ROIC needs to reinvest 50% of their earnings (0.10*.50=5.0%) and therefore only the other half of their earnings is available to distribute to shareholders. A company that generates 25% ROIC, on the other hand, only needs to reinvest 20% of their earnings to achieve 5% growth (0.25*0.2=5%) allowing them to distribute 80% of their earnings to shareholders.

Therefore the 10% ROIC company that earns $1.00 can distribute $0.50 to shareholders while growing 5%, while the 25% ROIC company earning $1.00 can distribute $0.80 to shareholders while growing 5%. Clearly, the higher ROIC business is more valuable. In fact, it is 60% more valuable than the 10% ROIC business (10% ROIC = 0.50/(.09-0.5) = $12.50 | 25% ROIC = 0.80/(.09-.05) = $20.00).

This dynamic is what leads to high ROIC businesses trading at high PE multiples, even when they don’t offer a lot of growth potential. Investors don’t get a share of earnings, they get a share of distributable cash. Since high ROIC businesses generate more distributable cash per dollar of earnings, their earnings are worth more to investors and thus their stocks are assigned higher PE ratios.

So we see that PE ratios are driven by both growth and return on invested capital. In our next post on this topic, we plan to show how high returns on capital persist for much longer periods of time than high growth rates, meaning that while both ROIC and growth generate value, high ROIC has a much more lasting impact.

*Readers familiar with the Gordon Growth model will notice we’ve redefined D1 as distributable cash rather than the dividend. The Gordon model assumes that distributable cash is paid as a dividend, but by redefining D1 to distributable cash directly, we allow the model to generate consistent valuations whether a company uses excess cash generation to pay dividends, buy back stock, pay down debt or buy other companies.

**A 9% required rate of return implies a 100% equity financed business. This example ignores the impact of financial leverage. Close readers will note that the example of a 10% ROIC business yields a PE of 12.5x. While this is below the market’s historical average PE, it is in line with the unlevered multiple. The average company’s ability to take on debt at a lower cost than equity reduces their cost of capital (r in the Gordon model) and increases their PE ratio.

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