That said, discounted cash flow models can always be mapped to "multiple-based" models. The issue there is that you'd better know what assumptions are baked in, and whether they're reasonable. For example, in an ideal world, a stock that earns E, pays a proportion d of that out in dividends, reinvests the rest to grow at a perfectly constant rate g, and is expected to stay in business into the indefinite future, should have a P/E ratio of d/(k-g) where k is the desired long term rate of return (say 0.10 or 10%) that the stock should be priced to deliver. For more on discounted dividends, see the September 12, 2005 comment, The S&P 500 as a Stream of Payments.
Unfortunately, all of this stuff gets abused. I remember in the market bubble of the late 1990's and into 2000, a bunch of Wall Street analysts were saying that stocks were saying that stocks were still cheap based on the dividend discount model. The problem was that they were assuming growth rates (g) of 10% or higher, when the peak-to-peak growth of S&P earnings and dividends had never exceeded 6-7% over periods of a decade or more. The Dow 36,000 guys basically tried to justify a P/E of 100 for the Dow by assuming that earnings were dividends, and then picking a "g" that was so close to "k" that the denominator of the above model was 0.01, or 1%. I wondered why they didn't go all the way and set k=g so they could publish "Dow Infinity."
But I digress.
The two main failures of standard FOE analysis are that 1) analysts assume a long-term norm for the P/E ratio that properly applies to trailing net, not forward operating earnings, and; 2) analysts fail to model the variation in prospective earnings growth induced by changes in the level of profit margins, and therefore wildly over- or underestimate long-term cash flows that are relevant to proper valuation. By dealing directly with those two issues, we can obtain useful implications about market valuation.
As I have frequently noted, it is not theory, but simple algebra, that the long-term annual total return for the S&P 500 over any horizon T can be written as:
Long term total return = (1+g)(future PE / current PE)^(1/T) - 1
+ dividend yield(current PE / future PE + 1) / 2
The first term is just the annualized capital gain, while the second term reasonably approximates the average dividend yield over the holding period. For the future P/E, one can apply a variety of historically observed P/E ratios in order to obtain a range of reasonable projections, but the most likely outcome turns out to be somewhere between the historical mean and median.
