Introduction on Stock Valuation
When it comes to writing about investing in common stocks, my favorite theme typically revolves around valuation. In fact, I once had a reader dub me “Mr. Valuation.” Which, I might add was very flattering to me. Moreover, in the context of discussing valuation there are normally three concepts that are included. They are typically fair valuation, undervaluation or overvaluation.
Oh, but would it not be wonderful, if everything about valuation were that simple. In truth, the concept of valuation is much more complex than those three simple notions. Therefore, one of the primary objectives of this article is to broaden the reader’s perspectives and understandings of the incredibly important concept of valuation as it relates to investing in common stocks.
However, before I delve too deeply into this subject, I would like to offer these following positioning statements. Position number one, just because a stock is technically trading at fair value, does not necessarily mean that it is a good or attractive investment. Position number two, just because a stock is moderately overvalued, does not necessarily mean that it is a poor or unattractive investment. In truth, there are circumstances where a moderately overvalued stock is actually a much better investment than a stock that is fairly valued. The key, as will be discussed later, revolves around the potential growth of the respective company.
The reason that the above positioning statements are true and valid is because valuation is only one component of many relating to common stock investment returns. There are many other factors such as the earnings growth rate of the stock in question, past, present and future, that will impact the future total return. Whether a company pays a dividend or not, and the level of the dividend it pays, if it does pay one, is also very important.
Therefore, to summarize, valuation is but one important component of successful stock investing. Furthermore, I would argue that valuation is more relevant to the soundness of the investment than it is to the total return the investment is capable of achieving. This is why (and I will elaborate more on this later on in the article) two companies with vastly different growth rates can technically be fairly valued with the same PE ratio. However, the potential future performance of each can be materially different as a function of each respective company’s growth potential.
A Conceptual Definition Of Fair Value
If you look up the term fair value on sites such as Investopedia or Wikipedia and others, you will discover what I believe are vague and even somewhat esoteric definitions. Therefore, I believe it is important that I offer my own definition of fair value so that the reader can at least be cognizant of the precise concept I am referring to. To me, fair value, as it relates to common stock investments, is manifest when the current earnings yield provided by the company’s profits, compensate me for the risk I am taking by providing both a realistic and acceptable return on my invested capital.
When referencing my definition of fair value, it’s important to focus on the concept “current earnings yield.” There a couple reasons why I feel this is both rational and important. First of all, the current earnings of a given business are typically precisely known (reported earnings). Therefore, the calculation of the return that the current earnings are offering me can be accurately calculated. To clarify a little farther, after years of extensive research and experience, I have determined (or at least satisfied myself) that a PE ratio of 15 represents fair valuation for the majority of companies based on realistically achievable growth rates.
In addition to the fact that after examining thousands of companies over several decades, through the lens of the FAST Graphs™ (Fundamentals Analyzer Software Tool), I have observed that a 15 PE ratio represents historical fair value for earnings growth up to 15% per annum. There are other logical facts that also support a 15 PE. First, I believe that it is not a coincidence that the more than 200-year average PE ratio of the S&P 500 is 15. Second, this is a fact because I believe it also represents, and is consistent with, the long-term average return of 6% to7% that common stocks have traditionally delivered to investors.
This fact is supported by the reality that a 15 PE ratio represents an earnings yield (E/P) of 6.67%, or approximately 6% to 7%. My point being, that this is a rational and realistically achievable rate of return commonly found in the real world of stock investing. But I believe the most important point regarding this 15 PE concept rests on the notion of soundness, not rate of return. When the current earnings yield is between 6% and 7%, the investment is currently attractive whether or not the business grows, and almost regardless of the company’s rate of growth (up to a point – 15%).
Moreover, I will further offer and contend that there is a logical reason why the growth rates on what I am calling the average company are represented with a rather broad range. That range is from 0% earnings growth up to 15% earnings growth. This notion is built on the reality that any future stream of income, whether it grows or not, is worth a multiple of itself. To be as clear as possible, I am suggesting, based on years of experience, that the fair value multiple will often equate to a PE of 15 (earnings yield 6%-7%) with regards to publicly traded common stocks, and private businesses for that matter. Allow me to offer the following allegory in order to establish the veracity of this claim.
Let’s assume that you owned a business that was generating you $100,000 per year of net net net income. Furthermore, let’s assume that the $100,000 per year was both fixed and guaranteed. But let’s further assume that it was now time for you to retire and sell your business. The seminal question is, what price would you be willing to accept from me, if I were a potential buyer?
If I offered you $100,000 (PE = 1), you would (or at least should) without hesitation turn me down because you would know that in one year’s time you would be broke. However, if I offered you $1,500,000 (a PE of 15) you might consider selling. Because, if you invested the $1,500,000 and received a 6.67% return (the earnings yield from a PE of 15) your income would be $100,500 per year, or approximately what the business was earning you. This is the essence of why a PE of 15 is both rational, normal and most importantly, sound.
Although the above allegory assumes a business with no growth, it is important that the reader recognize that growth will have an impact on what future return the buyer of the business would earn. However, the principle of soundness is based on the idea that both buyer and seller are receiving an acceptable and realistic return of 6%-7% even with no future growth.
Additionally, it should also be recognized that there is always risk in achieving a given level of growth. The higher the expected growth, typically the riskier it would be to achieve it. On the other hand, once again, the soundness of the transaction on the seller’s behalf is somewhat predicated on the notion that one in the hand is worth more than two in the bush. Therefore, the 15 PE in reality properly compensates both the buyer and seller of the business on a current earnings yield basis, regardless of future growth.
The PE Ratio as a Valuation Guide Not an Absolute
To me, the proofs of any hypothesis, especially those regarding investing in stocks, are so to speak in the pudding. In other words, if the hypothesis has any validity at all, you should be able to demonstrate it through real world, real life examples. Stated more directly, you should be able to measure the fair valuation PE ratio by examining actual companies and the typical historical valuations that have been applied to them.
Therefore, I will provide eight examples of companies with different earnings growth rates to illustrate how accurately the normal PE ratio as a proxy for fair value applies to companies with growth rates from 0% to 15%. However, three of my examples will show growth above 15% in order to demonstrate that above this threshold, higher PE ratios reflecting fair valuation are justified.
But before I provide the examples, there is one additional concept of incredible importance that I believe must be understood. The valuation discussions that I have presented in the context of this article should be thought of as guidelines representing a reasonably accurate reflection of fair value. It is vitally important that the reader does not try to become too precise with these notions. Although I fervently believe that fair valuation is a vital component of a successful stock investing strategy, I also understand that it needs to be thought of as a rational valuation array.
Consequently, as I will elaborate on with each following example, the reader should be focused on objectively determining whether these valuation guidelines have relevance or not on each specific case. As a clue, if these notions of valuation that I have presented are reasonably accurate, then we should see a very strong correlation between earnings and a 15 PE ratio in the long-term stock price movements for any company with growth from 0% to 15%. However, I repeat that this should be thought of as guidelines and not as absolutes.
The Fair Value 15 PE Ratio For Growth From 0% to 15%
In order to illustrate the validity of the fair value PE ratio of 15 on companies growing between 0% to 15%, I will review the historical earnings and price correlation of several companies through the lens of the fundamentals analyzer software tool FAST Graphs™. I will start by illustrating a company with historical earnings growth of only 1.5% and progressively move to higher and higher earnings growth examples.
With the first five examples, the reader should clearly understand and recognize that the orange line on the graph plots the company’s earnings per share at precisely a PE ratio of 15. Therefore, no matter where you look on that graph, the orange line represents a fair value PE of 15. As a result, the monthly closing stock price line (the black line on the graph) should closely follow and correlate to the orange earnings justified valuation line. Notice that when the price goes above the line how quickly it returns, and how when the price falls below the orange line how quickly it returns.
If my hypothesis is correct, there should be a high correlation between the stock price and the earnings line. Consequently, as you review each of the examples ask yourselves these simple questions: Does the orange line (PE=15) represent a sound price to pay if I really wanted to invest in this company? What typically happens in the future when the price goes above the orange line, and conversely what typically happens when the price falls below the orange line? Let the facts answer these questions for you. The idea is to try to visually recognize whether or not the fair value 15 PE ratio makes sense, or represents soundness.
Of equal importance, the reader should recognize that the slope of the orange line equates to the company’s historical earnings growth rate. This is shown in the green box within the FAST FACTS presented at the right of the graph. Therefore, also recognize that the capital appreciation component will be highly correlated to the company’s growth rate, assuming that fair valuation at the beginning and end of the period being measured is in alignment.
For extra credit, you might also notice that in the long run the stock price always moves to the orange line, thereby generating the capital appreciation component of total return. The light blue shaded area on the graph depicts dividends (see the color-coded section of the FAST FACTS to the right of the graph). Consequently, it should be clear that total return will be the combination of the capital appreciation based on earnings growth, plus the additional contribution from dividends.
Consolidated Edison (ED) 1.5% Earnings Growth
My first example reviews Consolidated Edison, a utility stock with a history of earnings growth only averaging 1.5% per annum. The orange line on the graph represents our theoretical fair value PE ratio of 15. To be clear, anywhere the stock price (the black line) touches the orange line it’s trading at a PE ratio of 15. Of course, if it’s above the orange line the PE is higher than 15, and if the price is below the orange line it’s lower.
But the most important point to be gleaned from the graph is that it is clear that you should never be willing to pay more than the fair value PE of 15 to buy this stock. Moreover, it is also clear that the stock price has gravitated to and tracked the orange line (PE of 15) over the long run. With Consolidated Edison’s growth as low as it is, investors can’t afford to have any material drop in price, because it would easily destroy any capital appreciation they could expect. Moreover, it’s also clear that even if this company is bought at a fair value PE of 15, it would be unreasonable to expect capital appreciation to be greater than the 1.5% earnings growth the company generates.
Furthermore, by examining the blue shaded area representing dividends, relative to the green shaded area representing earnings, it should be clear that Consolidated Edison pays the majority of its profits (approximately 70%) to shareholders, in the form of dividends. Consequently, it should also be clear that Consolidated Edison’s attractiveness is based more on the consistency and level of its dividend than on capital appreciation. Also, we can see that dividends provide a significant portion of shareholder’s total return.
Southern Company (SO) 3.2% Earnings Growth
Our second example, Southern Company, is also a utility stock. The primary difference in this example is that we are moving up the growth rate chain. Southern Company has averaged 3.2% earnings growth versus Consolidated Edison’s 1.5% earnings growth. Nevertheless, it should be clear that our fair value PE ratio of 15 continues to represent a clear proxy for fair valuation. Although the price line does on occasion move above and below our fair value PE of 15, it continuously moves back into alignment.
Once again we see that a PE ratio of 15 represents an undeniable proxy of fair value for Southern Company. It is easy to analyze the graph on Southern Company and conclude that we would never want to pay much more than 15 times earnings to invest in it. Moreover, notice how the price had risen above the fair value PE of 15 (the orange line) for much of 2012, but has since come back into alignment as the price is once again touching the orange line.
Bemis Company Inc (BMS) 5.6% Earnings Growth
Our third example, Bemis Company, a paper packaging company, moves up the growth chain with a historical average earnings growth rate of 5.6%. Nevertheless we once again see that the price tracks the orange line representing the fair value PE of 15. Therefore, at this point we see the relevance of the 15 PE over earnings growth rates ranging from 1.5% for Consolidated Edison to 5.6% for Bemis. But most importantly, we are seeing that the fair value PE continues to apply.
Cracker Barrel (CBRL) 7% Earnings Growth
Our fourth example, the restaurant chain, Cracker Barrel, has averaged 7% historical earnings growth which moves us approximately half way through our 0% to 15% range previously discussed. Once again, we see that our fair value PE represents a strong proxy for fair valuation, even at this higher earnings growth rate.
Remember, that this represents that a 15 PE is a sound investment, but that the total return will be a function of the company’s future earnings growth rate. Therefore, even though our PE of 15 still represents fair value, Cracker Barrel’s higher historical growth rate will generate more capital appreciation than we saw with our slow growth utility stocks.
United Technologies (UTX) 10.9% Earnings Growth
With United Technologies our historical earnings growth rate now exceeds 10%, yet we continue to see that our fair value PE of 15 continues to represent a clear proxy for fair value. In other words, by simply reviewing the graph, it is clear that a 15 PE ratio is a sound valuation to pay to buy United Technologies. Moreover, we also see that any time the price falls below our normal PE of 15, a bargain manifests. Conversely, we can also state that purchasing United Technologies at a PE ratio above 15 is not optimum.
AmerisourceBergen Corp. (ABC) 15.6% Earnings Growth
AmerisouceBergen Corp, our sixth example, is presented because it crosses over our upper threshold of an earnings growth rate of 15%. Once earnings growth exceeds 15%, the FAST Graphs™ research tool automatically applies the formula PE ratio = growth rate.
Therefore, the orange earnings justified valuation line in this example represents a PE ratio of 15.6. It should be clear that even though it is not precisely a PE of 15, it is very close. Moreover, AmerisourceBergen Corp also represents an example that PE ratios higher than 15 are justified when growth exceeds 15%. As growth rates exceed 15%, the fair value PE ratio will be higher reflecting this faster growth.
The Rule of 72
Without elaborating in great detail on why this is the case, allow me to simply offer the insight that the power of compounding comes into play at 15% growth and above. Once you get past 15% growth, the time it takes for a company’s earnings to double is shortened to the extent that a geometric factor begins to really kick in. Allow me to take the following sidebar to illustrate what is happening as growth exceeds 15% per annum.
The Rule of 72 represents a simple way to illustrate the geometric effects of compounding. To illustrate this, I will compare the long-term results of two hypothetical investments where one is growing at 10% (under the 15% threshold) and the other is growing at 20% (above the 15% threshold). I will assume a 36-year time period which theoretically represents a working lifetime. I have selected these numbers because they will clearly allow me to present what is hopefully an understandable portrayal of the compounding effect.
According to the Rule of 72, if I divide 10% into 72, it calculates that it will take 7.2 years to double my money at 10% growth. In contrast, if I divide 20% into 72, it calculates that it will take 3.6 years to double my money. With this information, I now know that at 10% growth, I will get 5 doubles on my money in 36 years (36 yrs./7.2 yrs. = 5 doubles). Therefore, my first dollar invested will double 5 times as follows: $2, $4, $8, $16, and finally $32 for my first dollar invested at 10% growth over 36 years.
However, at 20% growth, I will get 10 doubles on my money in 36 years, or double the doubles (36 yrs./3.6 yrs. = 10 doubles). Therefore, my first dollar invested will now double 10 times in 36 years as follows: $2, $4, $8, $16, $32, $64, $128, $256, $512, and finally $1,024. Therefore, my 20% return, which is double the 10% return, does not just double the amount of money I will earn, it doubles the number of times my money doubles over the same time frame.
For purposes of this article, our experience and research has shown that this effect begins to change the fair value PE ratio at the cross-over point starting at 15% growth. However, I would add as an aside that once growth exceeds 30%, the fair value PE ratio tops out. This concept would require another article to be fully developed, therefore I respectfully introduce it here in order to provide the beginning of insight into fair valuation at higher growth rates.
Ross Stores Inc (ROST) 17.2% Earnings Growth
Our seventh example, Ross Stores Inc, has a historical earnings growth rate of 17.2%. Now we are getting far enough above our average fair value PE ratio of 15 where we can see how faster growth finally warrants a higher PE ratio. The orange line on the Ross Stores’ graph represents a PE ratio of 17.2 with is equal to its earnings growth rate. With a close examination of the earnings and price relationship, it is clear that a 17.2 PE ratio represents a good proxy for fair value for Ross Stores Inc. More simply stated, it would have been historically sound to invest in Ross Stores at a PE of 17.
LKQ Corp (LKQ) 27.3% Earnings Growth
My final example reviews LKQ Corporation, a recycler of auto parts, with a historical earnings growth rate of 27.3%. For the first five years in this example, we see that the fair value PE ratio was the equivalent of the 27.3% earnings growth rate. Then the great recession lowered the PE ratio to the normal PE of 22.1. Nevertheless, this chart reveals that LKQ’s earnings growth rate has been significantly above 15%, and therefore, has commanded a significantly higher valuation. In other words, this stock could never have been bought at our 15 PE ratio, because the stock has never traded at such a low valuation thanks to its high growth.
The following table summarizes our eight examples which are presented in order of highest historical earnings growth to lowest. Although the fair value PE of 15 applies to all the companies below 15% earnings growth, as an indication of soundness, note that the annualized performance of each company closely correlates to its historical earnings growth.
This illustrates our thesis that although all the companies below 15% growth warrant a fair value PE of 15 to be considered sound investments, this does not mean that all of them will produce the same rates of return. The rate of return will be more a function of each company’s earnings growth rate, assuming that they are bought at the appropriate fair value PE of 15 for growth below 15%, and a PE ratio equal to the earnings growth rate for companies showing above 15% earnings growth.
The purpose of this article was to illustrate the principles and nuances of fairly valuing common stocks at various growth rates. Hopefully it also illustrated that valuation is a valid concept that helps determine whether the investment is sound or not.
However, it should also be recognized that fair valuation should always be thought of as a guideline rather than an absolute number. Furthermore, this does not diminish the value or importance of getting fair valuation right. Possessing a solid understanding of fair valuation is a vital prerequisite to successful common stock investing. Fair valuation is not meant to be rigidly adhered to. Instead, it should be thought of as an important tool in the investor’s arsenal assisting them with making sound and successful investments in common stocks.
Disclosure: Long UTX, ABC, ROST & LKQ at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
More Business articles from Business 2 Community: