Question

In 2000, the P/E ratio of the stock market reached about 45. If you assume that these corporations will grow roughly at the overall economy’s (GDP) growth rate of 4-5% per year, what should investors have reasonably expected in terms of a likely future rate of return implied by the stock market’s level? Show your work.

Answer 1

Let us assume that the current Earnings Per Share (EPS) of firms in the stock market is $ 1. The PE Ratio of the market is 45, thereby implying a price per share of $ 45 (PPS). If the corporations under consideration are expected to have a growth rate of 4-5% per annum, then expected earnings next year will be between (1x1.04) = $ 1.04 and (1x1.05) = $ 1.05.

Assuming that the PE Ratio remains constant at 45, the possible price range for stock next year is (45 x 1.04) = $ 46.8 and (1.05 x 45) = $ 47.25

Therefore, possible range of returns next year = [(46.8 - 45) / 45] to [(47.25 - 45) / 45] = 0.04 to 0.05 or 4 to 5 %