A share price is not an opinion about a company. It is a forecast, written in a code most people never decode.
The decoding takes one line. Start from the simplest valuation that exists — a price is the earnings divided by the return you require, less the growth you expect:
price = earnings ÷ (required return − growth)
Rearranged, so that growth is on its own:
implied growth = required return − (1 ÷ P/E)
That is the whole tool. One subtraction, and you have converted a number you cannot argue with into a number you can.
What each multiple is quietly assuming
Implied perpetual growth, at three different required returns
| P/E | If you require 8% | If you require 9% | If you require 10% |
|---|---|---|---|
| 12× | −0.3% | +0.7% | +1.7% |
| 15× | +1.3% | +2.3% | +3.3% |
| 20× | +3.0% | +4.0% | +5.0% |
| 25× | +4.0% | +5.0% | +6.0% |
| 30× | +4.7% | +5.7% | +6.7% |
| 45× | +5.8% | +6.8% | +7.8% |
| 48× | +5.9% | +6.9% | +7.9% |
Now read the table sideways, because that is where the surprises are. A stock at 12 times earnings is being priced for almost nothing — at a 9% required return, 0.7% growth for ever, roughly half of inflation. The market is not saying the company is bad. It is saying it will barely grow, permanently.
And at the other end: 48 times earnings implies 6.9% growth for ever. Not 30%. Not a doubling. Seven per cent — compounded without end, which is the genuinely hard part, but seven per cent.
A 48× multiple is not betting on a miracle. It is betting on seven per cent, for ever — and for ever is the word doing the work.
Three arguments this ends quickly
- "It's cheap at 12 times." Maybe. It is priced for permanent stagnation. If you think the business grows with inflation and no more, the price is correct and there is no bargain — just a fair price for a flat business.
- "It's absurd at 45 times." Also maybe. The price implies about 6.8%. Ask whether the business has grown faster than that for the last decade, and whether the thing that produced the growth is still there. Sometimes the answer makes 45 look careless; sometimes it makes it look unremarkable.
- "Rates don't matter for good companies." They do, arithmetically. Move the required return from 8% to 10% and every multiple in the table implies two extra points of growth to justify itself. Nothing happened to any business — the bar moved.
What this cannot do
It is not a valuation, and anybody using it as one will get hurt. The assumptions — everything paid out, constant growth, no end — are a caricature of a real company. A business that reinvests at high returns is worth more than this model says; one whose growth fades is worth less.
What survives the caricature is the shape. The direction of the answer, and its rough magnitude, do not depend on the model being right — they depend on arithmetic that holds for any discounted stream. That is why it is worth doing on the back of an envelope before spending an afternoon on a spreadsheet: it tells you whether the afternoon is warranted.
The required return is your input, not the market's. It is tempting to pick whichever number makes the answer agree with what you already believed. Choose it first, write it down, and use the same one across every company you examine — otherwise you are not valuing anything, you are rationalising.
A warehouse retailer near 48×, a consumer staple in the twenties, and a software business in between. Same arithmetic, three different questions.
What to do with this on Monday
Take your largest holding, find its P/E, decide what return you require, and do the subtraction. Then say out loud what the number means: "the market believes this company grows at X per cent for ever."
Most of the time you will find you agree, and the position becomes less exciting and more solid. Occasionally you will hear yourself say something you do not believe at all — and that sentence, said out loud, is worth more than any amount of reading about whether the market is expensive.
Frequently asked
How do you work out the growth rate a share price implies?
Start from the simplest valuation there is: price equals earnings divided by (the return you require minus the growth you expect). Rearranged, the growth being assumed is your required return minus the earnings yield — that is, minus one divided by the price-to-earnings ratio. At a 9% required return, a P/E of 25 implies about 5% growth, for ever.
Is a P/E of 30 expensive?
It implies roughly 5.7% growth for ever, at a 9% required return. Whether that is expensive depends entirely on the business: for a payments network it may be conservative, for a cyclical industrial it is close to fantasy. The multiple is not the answer — it is the question, converted into something you can actually have an opinion about.
Does this model actually work?
Not as a valuation, no. It assumes earnings are fully paid out and grow at a constant rate for ever, which describes no real company. It works as a translator: it converts a number you cannot judge (a multiple) into a number you can (a growth rate). The shape of the answer survives the crude assumptions even though the decimals do not.
Why does the required return matter so much?
Because it is the other half of the equation and it moves. At an 8% required return a P/E of 48 implies 5.9% growth; at 10% the same multiple implies 7.9%. Nothing about the company changed — but what you are demanding did, and that alone shifts the growth the price is assuming by two full points.