Research methods
Earnings growth vs. P/E re-rating: where does a stock’s return come from?
The short answer
A price expressed as EPS times P/E can rise because earnings grow, because investors pay more for each dollar of earnings, or both. These are separate assumptions. Their percentage effects multiply, so simply adding the earnings-growth rate to the multiple increase understates the combined change when both rise.
A target contains at least two judgments
A forecast of future earnings describes the business and its per-share economics. A target P/E describes how the market might price those earnings. A company can deliver the earnings forecast while investors continue to apply a lower multiple.
Before explaining a target, write the EPS period and accounting basis beside the multiple. Historical GAAP EPS and next-year adjusted EPS are not interchangeable. The table should also state the reference share-price date. A neat target is still a forecast assembled from assumptions.
Read the source: Investor.gov: Price-earnings (P/E) Ratio
Build a bridge that holds one assumption still
Suppose an invented stock has annual EPS of $3 and trades at 20 times earnings, giving a $60 price. The model forecasts EPS of $3.60 and assumes a future P/E of 25. The resulting $90 target requires both earnings delivery and a higher multiple.
Holding the original multiple at 20 gives $72, or 20% above the reference price. Moving from 20 to 25 times the higher EPS adds another $18. This earnings-first dollar bridge is useful, but the attribution depends on the order: changing the multiple first would allocate the interaction differently.
| Step | EPS | P/E | Implied price |
|---|---|---|---|
| Reference | 3.00 | 20× | $60 |
| Earnings growth; multiple unchanged | 3.60 | 20× | $72 |
| Earnings growth plus re-rating | 3.60 | 25× | $90 |
Read the source: Aswath Damodaran, NYU Stern: P/E and its determinants
The percentage changes multiply
The modeled price ratio is (future EPS ÷ starting EPS) × (future P/E ÷ starting P/E). In this example, 1.20 × 1.25 = 1.50: a 50% price increase. Adding 20% and 25% gives 45%, missing the five-percentage-point interaction.
This is a price calculation, not a total-return calculation. It excludes dividends, taxes, transaction costs and any other distributions. It also assumes that the EPS and price inputs refer to a consistent share and currency basis. The arithmetic verifies what the assumptions imply; it does not verify the assumptions themselves.
A falling multiple can outweigh growing EPS
Keep the same $3.60 future EPS but apply a 15 times P/E. The implied price is $54, or 10% below $60, despite the 20% earnings improvement. That is why business growth and shareholder price returns do not always move together.
A useful downside scenario should test both weaker earnings and a lower multiple. Do not call the result a price floor. The market can apply a multiple outside the chosen range, and the business can perform worse than the modeled case.
| Future P/E | Implied price | Price change vs. $60 |
|---|---|---|
| 15× | $54 | −10% |
| 20× | $72 | +20% |
| 25× | $90 | +50% |
Give the multiple its own evidence
Growth prospects, financial risk and the cash a business can distribute affect what an earnings multiple means. A higher multiple should not be justified only by saying that it is needed to reach the target. Peer multiples can provide context, but their business quality, leverage and earnings definitions need to be comparable.
Keep the unchanged-multiple outcome visible beside the headline target. It tells the reader how much of the price case depends on the company delivering earnings and how much depends on investors changing their assessment. Our Adobe sample uses that distinction explicitly, with a dated sensitivity rather than a promised return.
Read the source: Aswath Damodaran, NYU Stern: valuation approaches · C&C Research: valuation assumptions and sample sensitivity
Five questions for the next price-target headline
A compact worksheet can expose the main uncertainty without pretending to know the eventual price.
- Which future EPS period and accounting basis are used?
- What happens if the P/E stays unchanged?
- What supports the chosen multiple beyond the desired target?
- What happens if both earnings and the multiple disappoint?
- Are dividends and other return components included or excluded?