Determinants of the Price-to-Earnings Ratio

We examine a firm’s P/E ratio in the context of a model wherein firms make sequential investments in production capacity. In addition to investment growth, our analysis seeks to identify pricing power in the firm’s product markets and accounting conservatism as determinants of the P/E ratio. A benchmark result demonstrates that, given unbiased accounting, the firm’s P/E ratio can be expressed as a convex combination of the P/E ratios suggested respectively by the permanent earnings model and the Gordon growth model. The relative weight to be placed on these two endpoints is captured entirely by Tobin’s q. Relative to this benchmark result, we examine the behavior of the P/E ratio when the applicable accounting rules are conservative. In particular, the impact of higher past growth in investments on the P/E ratio is shown to depend on the degree of accounting conservatism.