P/E Multiple vs CAGR by Sure Dividend
Why does the value investing community focus so heavily on valuation multiples (P/E, P/B, P/S, EV/EBIT, etc.)? The only thing that really matters to investors is the compound annual growth rate (CAGR) they will receive from shares. The price you pay for a business significantly affects Your CAGR.
What Makes up CAGR
The CAGR for shareholders is made up of 3 things:
- Return from growth in business
- Return from dividends
- Return from changes in valuation multiple
Businesses have varying degrees of control over these 3 return sources. Profitable, stable businesses have the most control over how much they pay out in dividends.
They have some control over how quickly the business grows, depending on the projects they invest in, and the amount of stock they repurchase. Repurchasing shares increases the ownership of percentage of shareholders; it causes your stake in the company to grow.
Businesses have no control over the valuation multiple assigned to them. The market may say the business is worth 30x earnings one year, and then 15x the next year.
The Unbelievable Benefits of Compounding
If you find a business that grows at 5% a year (just 5%…), pays out 45% of its earnings as dividends, repurchases shares with 30% of earnings, and has a P/E ratio of 15, your money will double every 7 years if you reinvest your dividends each year. In just over 21 years, you will have 8x the amount of money you started with. Investing in businesses that reward shareholders with dividends and share repurchases while steadily growing year after year is a fantastic way to create wealth over time.
“Compound interest is the 8th wonder of the world. He who understands it, earns it… He who doesn’t… pays it”
-Albert Einstein
Valuation Ratios Really Matter
Take the same company we were discussing earlier. Everything is the same about it… Except you buy it at a P/E ratio of 25 instead of 15. After 5 years, the stock trades at a more reasonable P/E ratio of 15. How did your investment do? Instead of growing at over 10% a year, your investment would have lost money. In 5 years, you would not have broken even; even though you bought shares in a business that grew consistently, paid dividends, and repurchased shares.
Conclusion
Compounding your money in great businesses generates wealth only if the businesses are purchased at a fair price. Buying investments are just like buying anything else in life… You only get good value when you pay a fair (or better) price.
