Price and Dividend Multiples

Price to earnings (p/e) and its reciprocal (e/p) along with the dividend yield (d/p), where p is share price and e and d are earnings per share and dividend per share, are common multiples scrutinized by equity analysts and, as we shall see, have many applications. The concept of value stocks, for example, are stocks with low p/e ratios. The value is in the belief that the price is too low for the stated earnings per share and will therefore mean-revert earning the holder a greater return. Growth stocks, on the other hand, are stocks in companies whose earnings have shown high growth in the past and are expected to grow at above-average rates going forward. Growth companies are therefore those believed most capable of expanding earnings and revenue.

The growth and value concepts have spawned an industry in what is called style analysis—small versus big capitalization stocks and value versus growth. The original research was presented in a series of seminal papers by Kenneth French and Eugene Fama, who suggested the existence of certain style factors to supplement the single market index in the capital asset pricing model (CAPM). We will derive the CAPM in the next chapter. The point made here is that fundamental factors on market capitalization (size), and multiples describing book value to market value and earnings to price (value and growth) are instrumental in price determination. Figure 4.1, for example, is from French's website and describes how the universe of stocks can be divided on the basis of these factors.

Figure 4.1 Fama-French Style Analysis

High book-to-market value of equity (BE/ME) firms are those that the market currently undervalues, like a stock with a low p/e ratio. These are considered to be value bets. Conversely, low book-to-market value of equity is associated with growth stocks. Size is dimensioned on market value of equity, or what we call capitalization. For example, big stocks are those firms with above median capitalizations. Fama and French subtracted the returns of stocks in the bottom tier (thirtieth percentile) from those in the top tier (seventieth percentile) to construct a value factor (they call it HML—high minus low) and as well as a size factor (they call it SMB; small minus big) to supplement the single factor (the broad market return on the S&P 500) in the CAPM. We analyze the three-factor model and factor models, in general, in more detail in later chapters.

See Kenneth French's website for information and data on these fundamental attributes:

http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/index.html