Several years ago I queried if there was a rational, numerically meaningful reason for why the price-over-earning ratio for U.S. stocks as a whole historically has averaged around 15. Last week while reading one of Jeremy Siegel's _Stocks for the Long Run_ editions, I found this:
Siegel's reasoning is wrong from an accounting point of view.
Corporations make a certain return on assets (ROA), the corporations will borrow money by issuing bonds usually at lower cost than ROA. Equity = assets minus long-term debt (LTD). Return on equity (ROE) = Net profit / equity. ROE is important for stock holders if the corporation does the best thing with the net profit.
If the corporation invests the net profit in new production, earnings will grow.
If the corporation returns the earnings to the stock holder, the stock holder may find it hard to re-invest the dividends and get the return that the company can by re-investing the profits.