Financial Education

Rapidly growing companies typically have high Price/Earnings (P?E) ratios. The growth duration model relates the P/E ratio to its rate of growth and the expected duration of that growth. It is a function of expected earnings per share growth, the required rate of return on the stock, and the dividend payout ratio. Since most growth companies pay little or no dividend, if one assumes a constant risk between any two securities the entire difference in P/E can be attributed to the difference in expected growth. Namely, the current prices should be in direct proportion to the expected future earnings ratio that will prevail when the growth rates are equal (time T).

For growth company GC and the non-growth company (or overall market) MI, the relationship is:

{[P(GC)/E(GC)]/[P(MI)/E(MI)]} = {[1+G(GC)+D(GC)]/[1+G(MI)+D(MI)]}^T

where D = the dividend yield and G = the current growth rate.

To solve for T, you take the log of both sides:

ln{[P(GC)/E(GC)]/[P(MI)/E(MI)]} = Tln{[1+G(GC)+D(GC)]/[1+G(MI)+D(MI)]}

For more information, see all articles on: Investing in Stocks, Investment Returns, Valuation

See also:

The Gordon Growth Model

Multi-Stage Dividend Discount Models

Using Futures to Alter Risk in Fixed Income Portfolios

The H-Model Dividend Discount Model

Strengths and Weaknesses of the Gordon Growth Model