Volume 18, No. 1, 2020
Martin L. Leibowitz, Stanley Kogelman, and Anthony Bova
In this paper, time paths of P/Es are projected, by applying a theoretical model in which the totality of “fully anticipated” future “franchise” investments serve as the source of higher P/Es.
At the outset, the P/E path slowly ascends until the first franchise opportunity is reached and funded. The actual act of funding transforms the “anticipated” franchise value potential into “realized” value-equivalent earnings. This equivalence does not change the price in the P/E numerator but, the P/E ratio declines because the new earnings flow into the ratio’s denominator. The P/E decline bottoms out at a level based on new going-forward franchise investment potential and then rises until the next franchise event.
In summary, this saw tooth pattern should not be surprising. If we view a firm’s Franchise Value as a promise of future productive growth, then realization should lead to on-going Franchise Value declines – unless previously unexpected sources of future growth are uncovered. And, in actual markets, it is just such “unexpected” events and prospects – of both a positive as well as a negative nature – that intermittently bubble to the surface.
While admittedly based on a highly theoretical model with the limiting assumption of perfect foresight, this specter of a downward gravitational P/E pull should act as a cautionary note for analyses that project an existing high P/E forward onto a higher earnings level assumed to be reached at some future point in time.