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Myth-busting: Stock Valuation and Earnings Growth

There is a perpetual debate among equity investors about the relationship between valuations and future earnings growth

Dan Kemp 25 April, 2017 | 15:47
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There is a perpetual debate in financial markets about the relationship between valuations and future earnings growth. If we think through the logic, there are two fields of thought:

First, a statistically-minded investor would say that a high price-to-earnings ratio means an investor should expect higher earnings growth rates. Said simply, why would anyone want to purchase something that is more expensive unless they assumed the payoff would be higher? If Company A has a price-earnings ratio of 10x and Company B has a price-earnings ratio of 20x, Company B is expected to deliver higher growth rates to justify the cost.

Second, the opposing approach from a behaviourally-minded investor would suggest that valuations are a function of cycles. Specifically, low valuations tend to happen when people are scared, which typically occurs around the bottom of the earnings cycle. This provides a low base, and a platform where earnings growth is easier to achieve. High valuations, on the other hand, are potentially subject to a cyclical downturn which could put pressure on valuations.

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About Author

Dan Kemp

Dan Kemp  is Chief Investment Officer, Morningstar Investment Management EMEA

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