Equities · E2 · 9 min
Valuation for traders: P/E, yields and rates
Say how many years of profit a share costs, compare shares with bonds, and explain why rising interest rates hurt fast-growing companies most.
In the news: “Tech sells off as bond yields jump”: why the same rise in rates hurts some shares far more than others.
The essentials
- P/E ratio
- Share price divided by : how many years of profit you pay for. A share at £30 earning £1.50 a year trades on a of 20.
- Trailing and forward P/E
- A trailing P/E uses last year’s earnings; a forward P/E uses analysts’ forecast for next year. A trailing P/E of 30 against a forward P/E of 20 means profits are expected to rise by about half.
- Earnings yield
- The P/E turned upside down: the profit you buy for each £1 you pay. A P/E of 20 is an of 5%, which can be set directly against a bond’s .
- Equity risk premium
- The extra return for owning shares rather than safe bonds. A rough estimate is the earnings yield minus the on inflation-linked government bonds: 5% against 1.5% leaves about 3.5%.
- Why rates hit growth stocks hardest
- Higher bond yields raise the return investors require, so share values fall. With growth 2 points below that return, a one-point rise in yields cuts the value by a third; with growth 6 points below, by a seventh.
The dividend growth model
P = D ÷ (r − g)
- P
- the share’s value today
- D
- next year’s dividend per share
- r
- the return investors require: the government bond yield plus the equity risk premium
- g
- how fast dividends grow each year, for ever
How it works
1. Paying for profits
A share’s price is a number of years of its profit. Profit per share is , and price ÷ earnings per share is the : a share at £30 earning £1.50 a year trades on a P/E of 20. A shop bought for £150,000 that makes £10,000 a year costs 15 years of profit; shares are priced the same way.
2. Last year’s profit or next year’s
A trailing P/E divides by last year’s earnings. A forward P/E divides by analysts’ forecast for next year. Take a share at £30 that earned £1.50 last year and is forecast to earn £2 next year: trailing P/E 20, forward P/E 15. When the forward P/E is lower, profits are expected to grow.
3. Turn the P/E upside down
Divide earnings by price instead and you get the : the profit you buy for each £1 you pay. A P/E of 20 is an earnings yield of 1 ÷ 20 = 5%. Written as a yield, a share can be compared directly with the interest on a bond.
4. Shares against bonds
Company profits tend to rise with prices, so compare the earnings yield with a : the return on an inflation-linked government bond above inflation. The gap is a rough , the extra return for owning risky shares. An earnings yield of 5% against a real yield of 1.5% leaves about 3.5%.
5. Valuing a growing dividend
Say a share will pay a £2 dividend next year, growing 4% a year for ever, and you want an 8% return. It is worth £2 ÷ (8% − 4%) = £2 ÷ 0.04 = £50. That is the : price = next year’s dividend ÷ (required return − growth), or D ÷ (r − g).
6. Higher bond yields, lower prices
The return investors require starts from the yield on safe government bonds, plus the equity risk premium. So when bond yields rise, r rises and the value falls. In the last example, r going from 8% to 9% takes the share from £2 ÷ 0.04 = £50 to £2 ÷ 0.05 = £40: a 20% fall from a one-point move.
7. Why growth stocks fall most
Take the same one-point rise in r, from 8% to 9%. A mature company growing 2% sees r − g go from 6% to 7%: its value falls 14%. A fast grower at 6% sees r − g go from 2% to 3%: its value falls 33%. The thinner the gap, the more of the value lies in profits far in the future, and the bigger the hit. That sensitivity is .
8. The same model gives a P/E
Divide the model by earnings and you get a fair P/E: the share of profit paid out ÷ (r − g). A company paying out 60% of its profit, with r − g of 4%, deserves a P/E of 0.6 ÷ 0.04 = 15. The diagram below lets you move the bond yield and growth and watch this P/E change.
Try it
Move the bond yield, the risk premium and growth. The closer growth gets to the required return, the higher the P/E, and the more a rise in yields takes off it. An illustrative model.
Discount rate r = 4.00% + 4.00 pts = 8.00%r − g = 3.00 pts
| Risk-free yield | Your stock (5.00% growth) | Low-growth stock (1.5% growth) |
|---|---|---|
| 0% | no finite value | 24.0 |
| 2% | 60.0 | 13.3 |
| 4% | 20.0 | 9.2 |
| 6% | 12.0 | 7.1 |
| 8% | 8.6 | 5.7 |
- Justified P/E
- 20.0
- After yields +1 point
- 15.0 (−25.0%)
- Equity duration
- 33 years
- Low-growth stock
- 9.2 → 8.0 (−13.3%)
Worked example
Investors require 8% from two stocks. A mature one will pay £2.00 next year and grow 2% a year; a growth stock will pay £1.00 and grow 6%. Bond yields rise and the required return on both goes to 9%.
- Mature stock before: £2.00 ÷ (8% − 2%) = £2.00 ÷ 0.06 = £33.33.
- Mature stock after: £2.00 ÷ (9% − 2%) = £28.57, a fall of 14.3%.
- Growth stock before: £1.00 ÷ (8% − 6%) = £50.00.
- Growth stock after: £1.00 ÷ (9% − 6%) = £33.33, a fall of 33.3%.
The same one-point rise in rates costs the mature stock 14% and the growth stock 33%.
Check yourself
8 quick questions on the explanation above.
Practice
New numbers every set. Misses and guesses go into your review deck.
In the interview
Answer out loud in under a minute, then compare.
Why do higher rates hurt tech stocks more than banks?
Trailing P/E is 30 and forward is 20. What’s the market telling you?
Is the market expensive? How would you judge it?
Remember
Earnings yield = 1 ÷ P/E; P = D ÷ (r − g)
When growth sits close to the return investors require, the P/E is high and a rise in yields cuts it hardest.