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In Part 1 of this series found here, we voiced the notion that there are two primary attributes, valuation and the rate of change of earnings growth, which prudent investors can use to forecast the potential future returns on their stocks. However, Part 1 was primarily focused on ascertaining the principles which laid the foundation for sound current valuation.

In this Part 2, we will focus on how to utilize current valuation in conjunction with earnings growth rates in order to come up with a reasonable expectation of the future total returns a stock can be expected to provide. The point is that neither can be looked at in isolation.  In other words, the price you pay to buy the growth that the company ultimately delivers, will determine not only how much money you make (the percentage return on investment), but how much risk you took to make it.

Moreover, in Part 1, we concerned ourselves with defining historical norms relating to valuation, and then provided historical evidence to back them up. But even more importantly, we strove to illustrate that there is a practical rationale that underpinned our calculations of soundness. This practical rationale is the calculation of the earnings yield (earnings divided by price) that a given valuation (PE ratio) represents.

The general idea here is that a company’s profitability ought to represent an acceptable rate of return on your investment.  After all, when all is said and done, when you “invest” in a common stock you are buying the business.  If that business isn’t making enough money to give you a decent return on your investment, then common sense would indicate that you’re overpaying for it.

Another way of looking at this is to understand and acknowledge that a business gets its value from the amount of cash flow it is capable of generating for its stakeholders (owners or shareholders).  At this point, it’s important that the reader recognizes the previous statement as a metaphor.

In other words, we are using the word “cash flow” to represent the amount of money the business is making you if you are an owner. Furthermore, in the context of this article we consider the word “cash flow” as interchangeable with profits or earnings. Our objective is to focus on the essence of valuation so that the principle can be understood, and not get caught up in semantics or accounting convention.

Analogy of a Hypothetical Private Company

With this in mind, we offer the following analogy.  Let’s assume that you own a private business that pays you $100,000 a year of income (salary, dividends, bonuses, etc.). We will also assume that your business provides a guaranteed $100,000 per year in income, no risk and no growth. Furthermore, we also assume that you live in the perfect society with no taxes. Remember, our objective is to focus on the essence of valuation.

Now let’s further assume that you are tired of working and want to sell the business.  The seminal question is at what price will you be willing to sell?  The logical answer would be at some reasonable multiple of one year’s worth of your earnings. Put another way, if a business generates a predictable annual income stream, it has a value greater than that income stream, even at zero growth. Because logically, if you sold the business for only $100,000, or one times earnings, you would be out of money in one year.

Therefore, in order to sell, you would need a multiple of one year’s earnings that you can use to provide yourself a comparable future income stream in your new retirement.  If we use the multiple of 15 (a PE of 15), our standard of value presented in Part 1, we would get a selling price of $1,500,000.

Now, if we could invest the $1,500,000 into a passive investment (Bond, CD, Public Dividend Paying Stock, etc.) at our established historically reasonable return of 6.66% (PE=15), we discover that our income would be $99,900 per year (approximately $100,000 per year). Note: This provides some insight into the underlying reason for a normal PE of 15, because the historical average annual return on stocks has been approximately somewhere between 6-9%. Therefore, the return a 15 PE represents is both believable and historically achievable.

Consequently, both the seller and buyer in our metaphorical analogy would be provided a sound and reasonable return.  The seller can take the proceeds and generate a future return adequate enough to provide a comfortable retirement, and the buyer simultaneously is earning a reasonable return on their investment in the operating business. The point is that the income stream is driving the value, and it’s the income stream that gives a business its worth, whether it’s a publicly traded stock on an exchange, or private.

Risk, Return and the Valuation Relationships

Thus far, we have established a baseline of valuation using a hypothetical guaranteed and static income stream-no risk and no growth. However, in the real world, a business’ income stream is neither static nor guaranteed. Furthermore, the more dynamic the income stream, the more risk associated with achieving it.

Some cases in point would include the notions that faster growth is harder to achieve than slower growth, and consistent growth would be generally considered more predictable than cyclical growth. Therefore, we now introduce two new concepts; risk and compounding. Risk will tend to lower or reduce the valuation a prudent investor is willing to pay for a given investment, and a higher rate of earnings growth tends to increase future value (compounding).

Therefore, risk and earnings growth rates will represent counteracting forces affecting starting or current valuation (PE’s). This partially explains why a 3% grower (less risky to achieve) might command the same current valuation PE of, for example, an 11% or 12% grower (riskier and harder to achieve). But this is a critical point; the faster grower will generate a higher future return than the slower grower, ceteris paribas.

Pictures Are Worth a Thousand Words

From this point forward, we are going to rely on FAST Graphs’ earnings and price correlated graphs and performance charts to vividly express the valuation and return relationships. Therefore, the following pictures will more succinctly articulate the principles this series of articles has been developing. But for the reader to receive any insights from the graphics, a few words of explanation on them is in order.

  • The orange earnings justified valuation lines on each graph are calculated by applying widely accepted formulas commonly utilized to value a business. There is no manipulation or adjustments made. The PE ratios represented are calculated and applied for the time period graphed.
  • The slope of the orange earnings justified line is equal to the calculated earnings growth rate. Importantly, although the PE may be the same or similar for two respective companies, the growth rate (slope of the line) can differ dramatically (this is a key to return calculations).
  • The calculated PE ratio on each graph is the same for every point on the graph. The applicable PE is listed to the right of each graph in orange letters with the formula designation, GDF for Graham Dodd Formula, PEG for PEG ratio (PE=Growth Rate) and GDF-PEG representing an extrapolation between the other two.
  • The dark blue line
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