Three factors to consider while looking at market valuations

My discussions with a variety of market participants in the past couple of weeks indicate that we are at a stage in the market cycle when the investors and analysts begin to change their valuation arguments. It is important to remember that the return on the investment in publicly traded equities is a function of three factors: earnings growth; changes in price earnings ratio and dividend. Principally, an acceptable PER for a company's stock is defined by the return on equity or capital employed a company is able to generate on a sustainable basis and the growth rate of earnings that could be achieved on a sustainable basis. A company that could generate higher RoE/RoCE consistently and is likely to grow faster, is usually assigned a higher PER as compared to the ones that generate lower RoE/RoCE or have low or highly cyclical earnings growth. Sometimes, PER changes due to relative forces, e.g., a rise of PER in comparable foreign markets or a change in the return profile of alternative assets like bonds, gold, real estate, etc.