Essence of Value Investing is Soundness Not Rate of Return

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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

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