P/E Forwards and Their Orbits

From a theoretical viewpoint, earnings growth that follows the consensus should—all else being equal—result in rising or falling P/Es that provide the equity investor with the price appreciation needed to just meet the market's total return expectation. For a given earnings growth rate, this expectational equilibrium should move a fairly priced P/E toward a sequence of “forward” values that ultimately trace out an implied “P/E orbit.” For two-phase models with the typically higher level of first-phase growth, the P/E orbit will trace a smooth year-by-year descent from the starting P/E to the terminal, second-phase P/E. These descending forward P/Es provide a baseline that represents the inertial pricing paths implied by an unaltered consensus. Analysts who assign P/E estimates that diverge from this baseline path presumably believe that they have special insights that justify such a departure from the consensus-implied level. Awareness of the P/E orbit concept should help analysts avoid falling for the classic trap of “P/E myopia”—misestimating the prospective return by automatically applying a current P/E to future earnings levels derived from consensus growth projections.