Essence of Value Investing is Soundness Not Rate of Return

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component of a successful stock investing strategy, I also understand that it needs to be thought of as a rational valuation array.

Consequently, as I will elaborate on with each following example, the reader should be focused on objectively determining whether these valuation guidelines have relevance or not on each specific case.  As a clue, if these notions of valuation that I have presented are reasonably accurate, then we should see a very strong correlation between earnings and a 15 PE ratio in the long-term stock price movements for any company with growth from 0% to 15%.  However, I repeat that this should be thought of as guidelines and not as absolutes.

The Fair Value 15 PE Ratio For Growth From 0% to 15%

In order to illustrate the validity of the fair value PE ratio of 15 on companies growing between 0% to 15%, I will review the historical earnings and price correlation of several companies through the lens of the fundamentals analyzer software tool FAST Graphs™.  I will start by illustrating a company with historical earnings growth of only 1.5% and progressively move to higher and higher earnings growth examples.

With the first five examples, the reader should clearly understand and recognize that the orange line on the graph plots the company’s earnings per share at precisely a PE ratio of 15. Therefore, no matter where you look on that graph, the orange line represents a fair value PE of 15. As a result, the monthly closing stock price line (the black line on the graph) should closely follow and correlate to the orange earnings justified valuation line.  Notice that when the price goes above the line how quickly it returns, and how when the price falls below the orange line how quickly it returns.

If my hypothesis is correct, there should be a high correlation between the stock price and the earnings line.  Consequently, as you review each of the examples ask yourselves these simple questions:  Does the orange line (PE=15) represent a sound price to pay if I really wanted to invest in this company? What typically happens in the future when the price goes above the orange line, and conversely what typically happens when the price falls below the orange line?   Let the facts answer these questions for you.  The idea is to try to visually recognize whether or not the fair value 15 PE ratio makes sense, or represents soundness.

Of equal importance, the reader should recognize that the slope of the orange line equates to the company’s historical earnings growth rate. This is shown in the green box within the FAST FACTS presented at the right of the graph. Therefore, also recognize that the capital appreciation component will be highly correlated to the company’s growth rate, assuming that fair valuation at the beginning and end of the period being measured is in alignment.

For extra credit, you might also notice that in the long run the stock price always moves to the orange line, thereby generating the capital appreciation component of total return. The light blue shaded area on the graph depicts dividends (see the color-coded section of the FAST FACTS to the right of the graph).  Consequently, it should be clear that total return will be the combination of the capital appreciation based on earnings growth, plus the additional contribution from dividends.

Consolidated Edison (ED) 1.5% Earnings Growth

My first example reviews Consolidated Edison, Inc. (NYSE:ED), a utility stock with a history of earnings growth only averaging 1.5% per annum.  The orange line on the graph represents our theoretical fair value PE ratio of 15.  To be clear, anywhere the stock price (the black line) touches the orange line it’s trading at a PE ratio of 15.  Of course, if it’s above the orange line the PE is higher than 15, and if the price is below the orange line it’s lower.

But the most important point to be gleaned from the graph is that it is clear that you should never be willing to pay more than the fair value PE of 15 to buy this stock.  Moreover, it is also clear that the  stock price has gravitated to and tracked the orange line (PE of 15) over the long run.  With Consolidated Edison, Inc. (NYSE:ED)’s growth as low as it is, investors can’t afford to have any material drop in price, because it would easily destroy any capital appreciation they could expect.  Moreover, it’s also clear that even if this company is bought at a fair value PE of 15, it would be unreasonable to expect capital appreciation to be greater than the 1.5% earnings growth the company generates.

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