In a world without taxes, leverage or uncertainty, the theoretical price/earnings ratio (P/E) can be expressed as the sum of two components—a base P/E and a franchise P/E. The base P/E is derived from the capitalized value of current earnings and depends only on the market capitalization rate. In equilibrium, all firms of the same risk class have the same base P/E. Firms with higher P/Es must have a business franchise that leads to substantial opportunities to make investments in new projects that provide above-market rates of return. The impact of these projects on P/E is measured by the franchise factor. Even only moderately high P/Es require a high level of future “franchise investment.”
A first-cut approach to determining the effect of leverage on P/E assumes that the cost of debt remains constant at all levels of leverage and neglects both the default risk and bankruptcy costs associated with higher leverage ratios. This approach shows that there is a threshold P/E that separates two leverage response patterns. If a firm’s P/E is greater than the threshold value, leverage will increase its P/E. The opposite holds when P/E is below the threshold.
The magnitude of P/E change is modest for the parameter values that characterize most of corporate America. When taxation is introduced, the leverage effect is even more subdued. Across a wide range of financial structures, the key to high P/Es remains substantial franchise investments.