What typically occurs to the cost of equity when the P/E multiple is higher?

When the P/E (price-to-earnings) multiple is higher, it generally indicates that investors are willing to pay more for each dollar of earnings, reflecting optimism about the company's future growth prospects. This heightened investor expectation can lead to an increase in the perceived risk associated with equity investments.

As the P/E multiple rises, the underlying cost of equity is influenced primarily by the expectations surrounding future cash flows and the required return that investors demand for taking on that risk. An increasing P/E ratio suggests that investors expect higher returns in the future, which can drive up the cost of equity. Investors may require a higher return to compensate for the perceived higher risk or higher potential reward from growth, thus leading to an increase in the nominal cost of equity.

This relationship underscores a fundamental principle in finance: as market valuations rise (as evidenced by a higher P/E), the market generally anticipates greater risk or higher expected returns, resulting in a higher cost of equity. This is particularly relevant for companies that may face volatility in earnings or have a high degree of leverage, where investor risk perceptions can significantly influence cost structures.