Estimating the Expected Rate of Return on Equity Capital Implied by Forecasts of Earnings and Earnings Growth

Peter Easton
The Ohio State University

Abstract: Earnings multiples are the most common measure of relative value. The simplest multiple is the price-earnings (PE) ratio. In recent years a variant of the PE ratio – the PEG ratio (which is the PE ratio divided by the forecasted short-term earnings growth rate) – has become a popular means of ranking stocks. Proponents of the PEG ratio underscore the fact that it takes account of differences in short-run earnings growth and thus it provides a ranking that is superior to the ranking based on PE ratios. But even though the PEG ratio may provide an improvement over the PE ratio, it is arguably still too simplistic because it implicitly assumes that the short-run growth forecast also captures the long-run future. I provide a means of simultaneously estimating the expected rate of return and the change in earnings growth beyond the (short) forecast horizon – thereby refining the PEG ratio ranking. Although the correlation between the refined estimates and estimates of the expected rate of return implied by the PEG ratio is high supporting the use of the PEG ratio as a parsimonious way to rank stocks, the estimates based on the PEG ratio are biased downwards. This correlation is much lower and the downward bias is much larger for estimates of the expected rate of return based on the PE ratio. Evidence is provided that stocks for which the downward bias is higher can be identified a priori.

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