Growth and forward EP

Abstract

This paper explains forward earnings-to-price ratio (forward EP) from the growth perspective. The practical investment focuses on forward EP as it is a starting point to analyze whether investors over-pay for firms' future earnings. While, without understanding what growth is and how growth explain forward EP, investors are hard to assess whether forward EP is reasonable. Two growth measures are used in this paper. The first one, forward sales growth, captures firms' operating growth opportunities. It is calculated by analysts' consensus forecast sales, year t+2 relative to the forthcoming year t+1. The second one, book-to-market ratio, reflects both growth concept and application of accounting conservatism. Two growth measures are correlated with forward EP and similar in all 14 years. Two growth variables are mutually supporting: high forward sales growth implies a high (positive) BTM - EP correlation and low BTM implies a high (negative) forward sales growth - EP correlation. One special case of conceptual interest explicates growth irrelevance. First, when the book-to-market ratio approximates to 1, forward sales growth loses its explanatory power because the mark-to-market accounting discounts any benefits of positive NPV projects. Surprisingly, there is no evidence to show that risk can explain forward EP.