This article looks “inside” the DDM-based price/earnings ratio and provides a surprisingly simple model of the future investment opportunities required to support an above-market P/E. The analysis is done under the idealized assumptions of certain returns, no taxes and no leverage. Further, all stocks are taken to be priced according to the dividend discount model. Under these conditions, the ingredients of P/E expansion can be separated into two factors—(1) a Franchise Factor that represents the P/E impact of new investments at a specified return and (2) a growth measure that reflects the magnitude of these new investment opportunities.
The Franchise Factor depends on the return available on new investments. For at-market-rate returns, the Franchise Factor is zero. Consequently, investments that provide such returns do not add to the P/E. Only investments that provide above-market returns lead to a positive Franchise Factor and an above-market P/E. Two surprising results of the analysis are the small size of the Franchise Factor and the extraordinary magnitude of growth required to raise P/E significantly. For example, a firm with an ROE 300 basis points above the market rate must have franchise investment opportunities equivalent, in present-value terms, to five times its current book value to support a P/E that is twice the market rate.
The decomposition of the P/E suggested in this article allows the analyst to cut through the confusion that can arise from the standard DDM formulation, which intertwines assumptions regarding a constant-growth process, implicit return levels and dividend-payout policies. As a result, the Franchise Factor approach can provide a sharper understanding of the real ingredients that lead to higher equity values and better P/E multiples.