What's the connection between P/E ratio and growth?
So, the price-earnings ratio is price over earnings, easy enough. But obviously earnings are not static. In the case of a growing company, the earnings will be higher in the future. There will be extra earnings, above and beyond what the stock has right now. You should consider the future earnings in your estimate of what the company is worth now. One snag: Those extra earnings are future money. Future-money is an interesting thing, it's actually worth less than present-money- because of things like inflation, but also opportunity cost.  So if you bought $100 in money that you'll have 20 years from now, you'd expect to pay less than $100. (The US government can sell you that money. It's called a Series EE Savings Bond and it would cost you $50. I think. Don't quote me on that, though, ask the Treasury.) So you can't compare future money with present-money directly, and you can't just add those dollars to the earnings . You need to compute a discount. That's what discounted cash-flow analysis is about: figuring out the future cash flow, and then discounting the future figuring out what it's worth now. The actual way you use the discount rate in your formula is a little scarier than simple division, though, because it involves discounting each year's earnings (in this case, someone has asserted a discount of 11% a year, and five years of earnings growth of 10%). Wikipedia gives us the formula for the value of the future cash flow:  essentially adding all the future cash flows together, and then discounting them by a (compounded) rate. Please forgive me for not filling this formula out; I'm here for theory, not math. :)
"Yeah, I saw a similar article back in 1976 (and several times since).  But then they used the correct word ""exponential"" to refer to growth.  Ironically the author may end up being correct by using ""parabolic"" -- which is the type of curve you see with ""bubbles"", as the slow towards the peak and then begin descending with increased rapidity on the other side.  And (alas) solar electric power generation placements are very likely to follow THAT curve -- as the investments fail to pay off, people begin to realize that (despite the claims) it is *not* a viable long-term base of power-generation, and so begin to not only reduce investment, but to abandon and even scrap projects as the long term costs mount." Great question. Surprisingly, stock returns and GDP growth are mostly unrelated. In fact, they are slightly inversely correlated when you look across countries. Consider a firm that earns $100 on average per year with zero growth. If investors apply a 10% discount rate to this firm, the company will have a market value of $100/10% = $1,000. If it continues to earn $100 per year, it will produce 10% returns despite zero growth in earnings. You can see that realized returns are largely a function of the return investors demand for putting their money in risky assets.  I say mostly unrelated because an increase in GDP growth may increase our firms earnings (though the relationship to earnings per share is muddied by new share issuances, buybacks, M&amp;A, etc.). But you can see from the above example that returns can vastly exceed growth in perpetuity. I look at the following ratios and how these ratios developed over time, for instance how did valuation come down in a recession, what was the trough multiple during the Lehman crisis in 2008, how did a recession or good economy affect profitability of the company. Valuation metrics: Enterprise value / EBIT (EBIT = operating income) Enterprise value / sales (for fast growing companies as their operating profit is expected to be realized later in time) and P/E Profitability: Operating margin, which is EBIT / sales Cashflow / sales Business model stability and news flow "**[Corporate taxes suffocate growth](http://mises.org/daily/3024)**  Mises Daily: Wednesday, July 09, 2008 by Sterling T. Terrell  ........  Lower corporate taxes are associated with economic growth. This can be shown a priori and empirically.  A Priori  Corporate taxes reduce the profits of business owners. This is true because net income is reduced by the tax rate. For example, Firm X, with a $100 investment, earning a 7% return has an income — before taxes — of $7. With a 10% corporate tax rate, net income — after taxes — is $6.30. Firm X now has earned a 6.3% return. In contrast, a corporate tax rate of 40% reduces net income after taxes by $2.80 to $4.20, or a 4.2% after-tax return. **This rise in taxes, on the margin, reduces the profit-seeking incentive to take business risks. Why risk starting a biotech company when inflation-protected T-bill's will give you the same return? Entrepreneurs and venture capitalists less willing to take risk means less innovation and fewer innovative ideas being economically viable. This results in less economic growth. Conversely, higher returns on invested capital encourage investment and savings. All of this leads to more capital savings, more innovation, better technology, and higher wages.**  Further, the above example of Firm X is true if the firm does not have the pricing ability to transfer the tax to its customers. If the ability does exist, an increase in the corporate tax rate is really a tax on customers of the firm. In this case, consumers now have less to spend and save and the end result is the same.  Finally, a firm unable to pass on a tax increase or bear the reduced profit will either attempt to cut costs by reducing wages (among other costs) or be forced to go out of business.  **The main point is this: by definition, corporations do not pay taxes — people pay taxes. A corporate tax is either a tax on shareholders of the firm, customers of the firm, or employees of the firm. Less corporate tax means more innovation, capital savings, and spending by these groups — also known as economic growth.**  **Empirically**  After theory and logic tell us what is true, empiricism can confirm our result.  Thankfully, Professors Young Lee (Hanyang University) and Rodger Gordon (UC — San Diego) have done the work for us. In a 2005 journal article they concluded,  ""This paper finds that the corporate tax rate is significantly negatively correlated with economic growth in a cross-section data set of 70 countries during 1970–1997, controlling for many other determinants/covariates of economic growth.""  More specifically, they continue, ""The estimates suggest that cutting the corporate tax rate by 10 percentage points can increase the annual growth rate by around 1.1%.""[3]  Using these figures, Andrew Chamberlain of the Tax Foundation opines,  **""by cutting the U.S.'s combined federal and average state corporate tax rate from roughly 40 percent to 30 percent we could boost U.S. economic growth by around 1.1 percent per year — enough to double our nation's wealth every 63 years.[4]""**  **Even better, a cut from the actual corporate tax rate of 35% to a rate of 10% would double our nation's wealth every 30 years.**  **Life Savers moved production to Canada. Nabor Industries and Tyco International moved to Bermuda. Halliburton has announced a move to Dubai. In a globalizing economy, is it really a puzzle that firms prefer to operate in lower-taxing, less-regulated environments?**  These are examples of what can be seen. As Frédéric Bastiat reminds us, however, it is imperative to also account for what cannot be seen. What would the wealth of our nation be today if the corporate tax rate had always been 10% or less? What creature comforts would have been innovated? What new technologies brought to market? What diseases cured?  Due to a history of high corporate taxes these answers are not known, and we are worse off because of it.  Sterling T. Terrell is a Ph.D. candidate in the department of agricultural and applied economics at Texas Tech University." I find it somewhat doubtful that the US economy will grow by less than 16 billion in the next 33 years. 33 years ago the US had a GDP of just 4 Trillion. Yes i know that growth has slowed down considerably but I just don't see how the US economy will fail to double in such a long period of time.   Hell from 2015 to 2016 the US economy grew 530 billion dollars to 18.57 Trillion dollars. Assuming Growth stopped and we simply increased our GDP by that much every year we'd increase by that much in 33 years. But that's unlikely to happen over the long period and since growth is compounding I see us easily staying ahead of India. China only gets past us on PPP seeing as their nominal economy was practically flat last year due to a slump in the renimbi. Very difficult to determine. I know the article wasn't meant to be conclusive, so some additional considerations:  * Industries: other industries may be affected differently  * Population growth: if wage increase caused higher population growth, this would affect employment  * Employment demographics: what % of change is attributable to those jobs around the minimum wage level  * Sales (not profit): if the 'extra money to spend' theory holds, one would expect sales to have grown at an abnormal rate for affected industries  * Rate of technological adoption (proxy: CapEx): did businesses start to implement more/new technologies and within what time frame were/will these implemented GDP = total economic output (i.e. revenue), not income.  But for investments, income is what matters.  Add in productivity gains of around 2-3%/year due to technology and basic free market dynamics, and you will get closer to that 6% growth.  Some mention mergers and acquisitions, but really that's just another form of productivity gains by gaining economy of scale and synergies.  Now add in modest selective picking within the S&amp;P index towards those companies which are doing the most in our current economy. In the equity markets, the P/E is usually somewhere around 15.  The P/E can be viewed as the inverse of the rate of a perpetuity. Since the average is 15, and the E/P of that would be 6.7%, r should be 6.7% on average. If your business is growing, the growth rate can be incorporated like so: As you can see, a high g would make the price negative, in essence the seller should actually pay someone to take the business, but in reality, r is determined from the p and an estimated g. For a business of any growth rate, it's best to compare the multiple to the market, so for the average business in the market with your business's growth rate and industry, that P/E would be best applied to your company's income. GDP growth is one of several components of nominal equity returns; the (probably not comprehensive) list includes:  Real GDP/earnings growth  Inflation  Dividend payouts and share buybacks  Multiple expansion (the market willing to pay more per dollar of earnings)  Changes in interest rate expectations  As other comments mention you could also see larger companies tending to deliver higher returns as for any number of reasons related to M&amp;A, expansion into foreign markets, etc. Essentially, yes, Peter Lynch is talking about the PEG Ratio. The Price/Earnings to Growth (PEG) Ratio is where you take the p/e ratio and then divide that by the growth rate (which should include any dividends).  A lower number indicates that the stock is undervalued, and could be a good buy. Lynch's metric is the inverse of that: Growth rate divided by the p/e ratio.  It is the same idea, but in this case, a higher number indicates a good value for buying. In either case, the idea behind this ratio is that a fairly priced stock will have the p/e ratio equal the growth rate.  When your growth rate is larger than your p/e ratio, you are theoretically looking at an undervalued stock. When fundamentals such as P/E make a stock look overpriced, analysts often point to other metrics. The PEG ratio, for example, can be applied to cast growth companies in a better light.  Fundamental analysis is highly subjective. For further discussion on the pitfalls of fundamentals, I suggest A Random Walk Down Wall Street by Burton Malkiel. "If you look at the biotech breakdown, you'll find a lot of NAs when it comes to P/E since there are many young biotech companies that have yet to make a profit.  Thus, there may be something to be said for how is the entire industry stat computed. Biotechnology can include pharmaceutical companies that can have big profits due to patents on drugs. As an example, look at Shire PLC which has a P/E of 1243 which is pretty high with a Market Capitalization of over a billion dollars, so this isn't a small company.  I wonder what dot-com companies would have looked like in 1998/1999 that could well be similar as some industries will have bubbles you do realize, right? The reason for pointing out the Market Capitalization is that this a way to measure the size of a company, as this is merely the sum of all the stock of the company.  There could be small companies that have low market capitalizations that could have high P/Es as they are relatively young and could be believed to have enough hype that there is a great deal of confidence in the stock.  For example, Amazon.com was public for years before turning a profit.  In being without profits, there is no P/E and thus it is worth understanding the limitations of a P/E as the computation just takes the previous year's earnings for a company divided by the current stock price.  If the expected growth rate is high enough this can be a way to justify a high P/E for a stock.  The question you asked about an industry having this is the derivation from a set of stocks.  If most of the stocks are high enough, then whatever mean or median one wants to use as the ""industry average"" will come from that." Your analysis is correct.  The income statement from Google states that LinkedIn made $3.4 million in 2010 - the same number you backed into by using the P/E ratio.  As you point out, the company seems overvalued compared to other mature companies.  There are companies, however, that posts losses and still trade on exchanges for years.  How should these companies be valued?  As other posters have pointed out there are many different ways to value a company.  Some investors may be speculating on substantial growth.  Others may be speculating on IPO hype. Amazon did not make a profit until 2003.  Its stock had been around for years before that and even split many times.  If you bought the stock in 1998 and still have it you would be doing quite well. There are books on the subject of valuing stocks. P/E ratio has nothing directly to do with the value of a company. It may be an indication that the stock is undervalued or overvalued, but does not indicate the value itself. The direct value of company is what it would fetch if it was liquidated. For example, if you bought a dry cleaner and sold all of the equipment and receivables, how much would you get? To value a living company, you can treat it like a bond. For example, assume the company generates $1 million in profit every year and has a liquidation value of $2 million. Given the risk profile of the business, let's say we would like to make 8% on average per year, then the value of the business is approximately $1/0.08 + $2 = $14.5 million to us. To someone who expects to make more or less the value might be different. If the company has growth potential, you can adjust this figure by estimating the estimated income at different percentage chances of growth and decline, a growth curve so to speak. The value is then the net area under this curve.  Of course, if you do this for NYSE and most NASDAQ stocks you will find that they have a capitalization way over these amounts. That is because they are being used as a store of wealth. People are buying the stocks just as a way to store money, not necessarily make a profit. It's kind of like buying land. Even though the land may never give you a penny of profit, you know you can always sell it and get your money back. Because of this, it is difficult to value high-profile equities. You are dealing with human psychology, not pennies and dollars. I think the straight productivity curve is supposed to represent the idea that the economy is always growing as opposed to shrinking overall, like you said. I beleive the video leaves out the idea of innovation to keep it simpler and cut down on length(Of an already half hour video). Thanks for the connection between innovation and productivity. Im new to this stuff and it hadn't occured to me.