[samvher]

I've also been thinking along those lines - it seems logical to me that if you expect ~7% yearly profit that the P/E ratio should be around 14 (1 / 0.07) and that if the market is very competitive (lots of available capital, low perceived risk, low-yielding alternatives such as bonds) and therefore you expect ~4% yearly profit the P/E ratio should be around 25 (1 / 0.04). However I have never really encountered this explanation anywhere which makes me wonder whether my reasoning is somehow wrong.

[myle]

The denominator E goes up over time. If ratio is constant, then P also goes up.

[samvher]

Yes I think that makes sense. If you have real economic growth that can cause E to rise and through that mechanism P to rise. But even without economic growth, by reducing expected returns, you can keep E constant and get P to rise by increasing the P/E ratio. My sense is that historically the first mechanism was more important, but in the last 10 years the second played an important role.