We believe there are two critical attributes that the prudent investor should consider before investing in a company (stock). Furthermore, these same two attributes can be used to calculate a reasonable expectation of the future return the stock is capable of generating on their behalf. These two attributes are valuation and the rate of change of earnings growth. Valuation indicates whether or not the company’s current earnings power compensates you for the risk you take, while the company’s future rate of change of earnings growth will be the driver of future returns.
We believe these are very important concepts for prudent investors to understand for several reasons. First of all, you can make an investment at fair value into a low or slow growth company, and still not generate a high rate of return. On the other hand, the risk associated with achieving it is normally low. This is simply because achieving a low rate of earnings growth is easier to do. Conversely, you could overpay, perhaps even significantly so, for a very powerful or fast grower and still make a high rate of return, because of the power of compounding.
However, by overpaying you are taking on more risk than you should for two reasons. First of all, the probability of a company achieving a very high rate of growth is very low, and second, longer term it’s virtually a given that price will return to fair value. Therefore, the investor will not be able to harvest the full measure of the company’s growth achievement. More simply stated, the probability of a future PE contraction is very high. The effect is a lower rate of return than deserved, while illogically taking a higher level of risk than necessary to obtain the lower return.
To summarize, if a company grows fast enough, then future earnings growth can overcome a high beginning valuation. However, the risk taken to achieve it is amplified by the high valuation. Conversely, if you come across an opportunity to buy a stock at a very low valuation, even a low growth company, your return potential is greatly enhanced while simultaneously your risk is greatly lessened.
On the other hand, overpaying for a slow grower (for example, a typical utility stock) destroys your return potential while simultaneously turning what might normally be a low-risk investment into a high risk investment. In the same vein, if you can find a slow grower that is significantly undervalued, you could generate a high return and arguably achieve it at very low risk.
As stated in our introduction, valuation is one of what we believe to be the two most important attributes that investors should consider before investing in a stock. Yet, fair valuation alone does not automatically indicate a high future return or even an adequate one. In truth, valuation is a relative concept that becomes relevant to future return only when looked at in conjunction with future growth. Throughout this report, we will illustrate that valuation unto itself is most relevant in the context of current time. In other words, valuation itself applies predominantly to current fundamentals. Consequently, we see valuation more as a measurement of soundness than we do as a rate of return expectation.
As a result, both a moderately fast-growing stock and a very slow-growing stock can command the same valuation in current time. However, given fair valuation for both, the faster grower offers a higher future return. This concept can apply to all classes of stocks to include non-dividend paying stocks as well as dividend paying stocks (Later in this article I will more clearly reveal this principle with specific examples). The point I am stressing is that valuation is more related to soundness than it is to future returns. Even more simply stated, valuation is about prudent behavior and risk mitigation.
To illustrate this more clearly, we are going to utilize the most common valuation measurement, the PE ratio. But first and foremost, we want to emphatically state that the PE ratio is more than a mere statistical inference. Instead, our objective is to illuminate the idea that the PE ratio is a relevant measurement of valuation that represents the appropriate compensation for the amount of risk currently being assumed. The key to understanding this is to recognize the PE ratio as a measurement of the earnings yield the investment is offering.
To put this into perspective, consider that the long-term average PE ratio of the S&P 500 has been, depending on the time frame being measured, somewhere between 14 to 16 times earnings (S&P 500 average PE 14 – 16). Jeremy Siegel, professor of finance at the Wharton School of the University of Pennsylvania has written that stocks have returned an average of 6.5% to 7% per year, after inflation, over the last 200 years. For simplicity sake, we are going to hang our hats on the historical average S&P 500 PE ratio of 15.
Now, up to this point, the average PE ratio of 15 for the S&P 500 is simply a statistic. However, a statistic is information, but information alone is not wisdom. To our way of thinking, answering the important question as to why a PE ratio of 15 is common over such a long period of time, is more critical than simply knowing the number itself. In order to accomplish this, let’s analyze what PE ratios of 14 – 16 translate into in terms of rate of return calculations. What we discover is that a PE ratio of 15 represents a reasonable and attractive rate of return of approximately 6% to 7%, that has historically been achieved (the long-term stock market average), and therefore logically considered acceptable and achievable.
To add clarity to this point, let’s actually calculate the rate of return (earnings yield) that a PE of 14, 15 or 16 represents. To determine the earnings yield, simply reverse the PE ratio (Price divided by Earnings) and calculate the EP ratio (Earnings divided by Price). Therefore, we learn that a PE ratio of 14 equals an earnings yield of 7.1%, a PE ratio of 15 equals an earnings yield of 6.66% and finally a PE ratio of 16 equals an earnings yield of 6.25%. Therefore, we learn through wisdom, that it is no coincidence that these calculations coincide almost perfectly with Prof. Jeremy Siegel’s historical statistic of average stock market returns of 6.5% to 7%.
In other words, an average stock market PE of approximately 15 (14-16) is rational and makes economic sense because it represents an appropriate yield on investment, which is why it is so commonly applied to the valuation of most stocks. However, for this to be relevant enough to be considered wisdom, it needs to also practically apply in real world circumstances. To practically apply, we must be able to see and measure evidence that clearly shows that the average fair value PE ratio of 15 actually does manifest in reality.
Testing the Fair Value 15 PE Ratio Hypothesis
In order to test the fair value