What drives a company's P/E ratio?
Linking valuation multiples to fundamentals.
Answer it out loud firstTake 30–60 seconds, as you would in the room. Then compare with the model answer.
Show the model answer
Growth, return on equity and risk. A company that grows earnings faster, earns a higher return on what it reinvests and has less risky cash flows deserves a higher P/E. A simple dividend-growth model makes it explicit: P/E = payout ratio ÷ (cost of equity − growth) — higher growth or a lower cost of equity raises the multiple, and interest rates move all P/Es through the cost of equity.
The full answer
Forward P/E = payout ratio ÷ (cost of equity − growth)
Sustainable growth = return on equity × (1 − payout ratio)
Example
Cost of equity 9%, payout 50%.
- Growth 4% → P/E = 0.5 ÷ 5% = 10x.
- Growth 6% → P/E = 0.5 ÷ 3% = 16.7x.
Small changes in growth or the cost of equity move the multiple a lot — which is why long-duration growth stocks are so sensitive to interest rates.
Other factors
Earnings quality, accounting choices, the position in the cycle, and market sentiment.
Mistakes to avoid
Saying only "growth" without risk and returns.
Follow-ups they may ask
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