Risk and P/E Ratio

[I_m_legend]

How can risk affect the P/E ratio of a firm? Or more accurately how can risk be related to P/E ratio?
In most cases, a higher-than-average P/E ratio would mean that the firm is in a growing phase. This is obvious because of the fact that a growing firm has more growth opportunities (a lot of positive NPV scenarios) compared to its current earnings that would increase the P/E ratio. So, does this show risk? Empirical studies have shown in many cases that a growth firm is risky because investors pay for the potential future growth opportunities which might be washed out by market forces at a certain point in future. If it is still true that growth firms are risky ventures, why would that firm still maintain a high-than-average P/E ratio? Because high risk is inbuilt within the required rate
of return (discount rate), the price should come down when investors discount the future growth cash flows by a higher discount rate. Even if we don’t get into DCF, I don’t know why a higher-than-average P/E ratio will persist even in a short term. Because investors know that the venture is risky, they won’t go for buying it. The price is supposed to get deflated just because over-supply and under-demand scenario. Again we should expect that the P/E ratio should converge to the industry average over time through market corrections, right? And at the end of the day, who would pay high for a lower amount of earnings?

 

[cykor21]

Quote: (…) Because high risk is inbuilt within the required rate of return (discount rate), the price should come down when investors discount the future growth cash flows by a higher discount rate.

Yes, a higher discount rate is applied but simultanously cash flows are assumed to grow at an extraoridnary high rate so in the end the price valuation might be higher than industry average.

Quote: Even if we don’t get into DCF, I don’t know why a higher-than-average P/E ratio will persist even in a short term. Because investors know that ohe venture is risky, they won’t go for buying it.

This has to do with investors’ risk preferences; a high P/E will persist as long as the market is convinced that this is the fair value.

 

[maratikus]

P/E ratios for growth firms might be too high because investors might be over-optimistic about the future of growth firms and they get hurt. Think of the value factor in the Fama-French model - growth firms have negative loadings on the factor.

 

[mat tye]

P/E Ratios should be inversely related to the risk of the firm. Investors will be less willing to pay large premiums for riskier cash flows. Banks, for example, are highly leveraged and enjoy much lower P/E Ratio’s than other industries.