Just been reading "The Dark Side of Valuation" by Damodaran, some interesting thoughts on the PE ratio...

Normally for most people when they see the PE ratio they think price per share divided by earnings per share. While this is correct it is a simplistic way of seeing it and loses all the details of the real factors that comprise the PE ratio and some of the fundamental drivers of value.

For an alternative look at the PE ratio try this:

PE = DPR*(1+G)/(R-G)

DPR = dividend pay out ratio (DPS/EPS) [dividend per share/earnings per share]
G = growth rate
R = required return/cost of equity capital

The above three elements contain the three key drivers of value:
DPR = cash flows
G = growth
R = risk

Thus, while it is intuitively obvious that these three factors should be important - in the above formula you can see how they can be demonstrated to drive value.
Specifically, higher cash flows, higher growth and lower risk lead to a higher PE ratio.



Additional notes:
G = Growth
A simple method of calculating the sustainable growth rate is produced from the ROE and the retention rate i.e. G = ROE*(1-DPR) thus the logic is that any earnings not paid out as dividends will be retained and reinvested at the current ROE (so assumptions apply, but in theory it kinda makes sense).
R = Required return
Usually this is derived from the CAPM i.e. R=Rf+B(Rm-Rf) where Rf = risk free interest rate B = Beta and Rm = market return. Thus the CAPM takes the risk free rate and adds a risk adjusted market risk premium to it - so you can see that the Beta is the proxy for risk in the PE model above.