List of References
Whelan, K., 1999, “Computers, Obsolescence, and Productivity” Finance and Economics Discussion Series, February, Federal Reserve Board, Washington DC.
Prepared by Martin Cerisola and Gustavo Ramirez.
This average is calculated for the period 1954-94, excluding the higher inflation sub-period 1970-84. High inflation biases P/E ratios downwards because it tends to adversely affect the quality of reported earnings. In particular, high-inflation periods tend to overstate reported earnings through the effect on depreciation allowances and inventory valuation.
The growth rate of earnings per share in real terms is calculated by deflating the growth in nominal earnings per share with the chain-type GDP price deflator. Growth in real earnings per share has been broadly in line with the growth rate of real GDP in the United States, reflecting the fact that the share of capital in national income has been relatively stable over time.
For a constant dividend-payout ratio d and a constant rate of growth in earnings per share g, the price-earnings ratio can be expressed as follows:
where r is the expected return on equity capital. In the results presented here, r is approximated by the yield on a risk-free asset (the ten-year U.S. government bond) plus a risk premium.
The real return on U.S. equities was 7.1 percent between 1946 and 1996 (Siegel (1998)). The real return on ten-year U.S. government bonds was about 2½ percent during the same period, which would suggest an equity premium of roughly 4½ percent. However, as noted by Siegel, depending on which risk-free asset is chosen, the equity premium could be as high 6 as percent on average. If the equity premium were 6 percent, a P/E ratio of 31 would suggest that investors expect real earnings to grow by 8¾ percent per year.
Price-earnings ratios for the industrial, transportation, utilities, and financial sectors, declined somewhat during the first quarter of 2000. However, the decline does not change the main results and conclusions presented in the paper. In particular, most of the industrial subsectors have experienced a decline in their P/E ratios, but these ratios remain significantly above their long-term average. In addition, while the P/E ratio for the technology subsector has risen markedly in the first quarter, price developments since then would suggest that the P/E may have declined sharply.
The situation is likely to change, as more states move forward in deregulating utilities, particularly in the energy sector.
The elasticities of the price-earnings ratio to earnings per share growth (ηg), the risk-free rate (ηrf), and the equity premium (ηρ), are defined as follows:
where ρ is the equity-risk premium and r =rf + ρ