In Part 1 and Part 2 of this three-part series, we established the basic principles of valuation and provided evidence that backs those principles up. Then we demonstrated that valuation is a function of soundness based on the current earnings yield that any given level of earnings offers you. From there, we illustrated how the future rate of earnings growth, in conjunction with fair valuation, will be the primary determinants of future returns.
A lot of what Part 1 and Part 2 were attempting to convey is the logical and common sense nature of valuation in regards to sensible stock investing. When the investor has a solid foundation of what real valuation is all about, they are less likely to be enticed into making bad decisions by an often emotionally-charged stock market. Therefore, extreme and anomalous market behavior can be recognized and dealt with accordingly. In other words, fear and greed can be controlled, thus paving the way for dialectic thinking.
Moreover, we tried to point out that valuation is about determining reasonable ranges of fair value. In other words, fair value is perhaps more a metaphor than a precise or absolute calculation. Furthermore, we demonstrated that a normal PE ratio of 15 represents a standard fair valuation for companies whose earnings growth rates range from 0% to 15%. Once again, the PE 15 is not necessarily a perfect number; instead, it indicates a sound valuation that represents an earnings yield of 6% to 7%.
Therefore, and for example, the difference between a PE valuation of 14, 15 or 16 is not that material to the long-term investor. Obviously, the lower the PE ratio you can purchase a company at the better. But the real value in considering valuation is the determination as to whether the investment makes economic sense and whether or not the risk taken is acceptable.
To put it another way, higher PE ratios indicate a significantly lower return on investment (earnings yield) than prudence would dictate. In the same vein, extremely low PE ratios would indicate great opportunity, assuming that earnings are not collapsing. Consequently, two points come logically into view: Aberrant PE ratios indicate valuation imbalances, and the necessity of forecasting future earnings growth is of high importance.
Forecasting Future Earnings – The Key
Once you have determined that fair valuation, plus or minus, exists, then the prudent investor should look to future earnings growth as the likely source of future long-term returns. Then, by applying the same principles that we presented and discussed in Parts 1 and 2, we can calculate within a reasonable range of predictability what our future returns might be.
There are several methods that can be used to forecast future earnings, however, we should always remember that these are forecasts and therefore, by their very nature, imperfect. Nevertheless, having a reasonable expectation of what future returns you can expect is a lot better than hope. Furthermore, once you have purchased a stock you can use this knowledge to make smarter and sounder future buy, sell or hold decisions. In other words, you can manage your portfolios more intelligently and effectively.
Extensive Comprehensive Research Effort
At the end of the day, there is no substitute for a comprehensive research effort and analysis. Even then, it would be naïve to expect perfection. However, the prudent investor should be capable of determining reasonable expectations that can be relied upon to make intelligent long-term investing decisions. However, it should never be forgotten that these decisions must be continuously monitored and kept up-to-date. Therefore, our first approach is to recommend a comprehensive research effort. For the sake of this article we once again rely on the F.A.S.T. Graphs™ research tool to facilitate this process.
In Part 1 and Part 2 we focused primarily on historical graphs that provided evidence supporting our thesis under real-world situations. Here in Part 3, we are going to move on by focusing on the Estimated Earnings and Return Calculator and the Earnings Yield Estimator. It’s important to realize that these tools are calculators that simply compute whatever data is fed into them. They also offer an override feature that allows the user to input their own estimates of their choosing, thereby generating their own forecasts.
Nonsubscribers to F.A.S.T. Graphs™ could utilize spreadsheets or other calculating tools in order to run their own numbers. However, the important point is that we believe that prudent long-term fundamental investors should be making these types of calculations. Because, we further believe that investors that have a realistic view of what their future returns may be, are better prepared to handle whatever challenges the marketplace may bring.
Estimating Future Earnings to Calculate Future Returns
For simplicity and space constraints, we are going to look at three sample companies to forecast future earnings growth and calculate future returns based on the standard 15 PE ratio. We will look at one that historically has grown at 5% or lower, one that is between 5% – 10%, and finally, one that is above 10% and approaching our 15% inflection point. Then we will offer a fourth and final sample that looks at growth above 15% where PEG ratio valuation comes into play.
Less Than 5% Growth – MGE Energy Inc (MGEE)
MGE Energy, Inc. (NASDAQ:MGEE) is a holding company based in Madison, Wisconsin. It is the parent company of the regulated utility Madison Gas and Electric Co. and other subsidiaries. The 15-year historical F.A.S.T. Graphs™ shows that the company’s earnings growth rate has been less than 5%. Moreover, we see the earnings and price relationship once again revealed. Clearly, this company has historically traded between our standard PE ratio of 15 and the company’s calculated normal PE ratio of 16.7. Most importantly, whenever it deviated from these fair valuation standards, price inevitably and quickly reverted to the mean.
From a long-term performance point of view associated with the above earnings and price correlated graphic, we discover performance that correlates to earnings. However, the reader might note that the starting dividend yield in 1998 would have been 5.6%, which is materially higher than today’s 3.1%. This provides another good indicator of overvaluation.
Although the forecasting graph (estimated earnings and return calculator) only shows one analyst forecasting future growth of 4%, it should be noted that this growth rate is also consistent with the company’s most recent five-year average. Consequently, given the long-term historical consistency of this regulated utility, a 4% growth rate seems plausible.
Note, for the reader to get the maximum benefit out of interpreting the forecasting charts, a few words of explanation are in order. The Estimated Earnings and Return Calculator provides both near and long-range forecasts. Specific earnings forecasts expressed in dollars are provided for the most current fiscal year and the next fiscal year. Then, the computer simply calculates future earnings beyond that point at the consensus five-year estimated growth rate, or the most recent five-year historical average.
Note that MGE Energy is currently trading at a PE ratio of 18.3 which