rate.
Therefore, the orange earnings justified valuation line in this example represents a PE ratio of 15.6. It should be clear that even though it is not precisely a PE of 15, it is very close. Moreover, AmerisourceBergen Corp also represents an example that PE ratios higher than 15 are justified when growth exceeds 15%. As growth rates exceed 15%, the fair value PE ratio will be higher reflecting this faster growth.
The Rule of 72
Without elaborating in great detail on why this is the case, allow me to simply offer the insight that the power of compounding comes into play at 15% growth and above. Once you get past 15% growth, the time it takes for a company’s earnings to double is shortened to the extent that a geometric factor begins to really kick in. Allow me to take the following sidebar to illustrate what is happening as growth exceeds 15% per annum.
The Rule of 72 represents a simple way to illustrate the geometric effects of compounding. To illustrate this, I will compare the long-term results of two hypothetical investments where one is growing at 10% (under the 15% threshold) and the other is growing at 20% (above the 15% threshold). I will assume a 36-year time period which theoretically represents a working lifetime. I have selected these numbers because they will clearly allow me to present what is hopefully an understandable portrayal of the compounding effect.
According to the Rule of 72, if I divide 10% into 72, it calculates that it will take 7.2 years to double my money at 10% growth. In contrast, if I divide 20% into 72, it calculates that it will take 3.6 years to double my money. With this information, I now know that at 10% growth, I will get 5 doubles on my money in 36 years (36 yrs./7.2 yrs. = 5 doubles). Therefore, my first dollar invested will double 5 times as follows: $2, $4, $8, $16, and finally $32 for my first dollar invested at 10% growth over 36 years.
However, at 20% growth, I will get 10 doubles on my money in 36 years, or double the doubles (36 yrs./3.6 yrs. = 10 doubles). Therefore, my first dollar invested will now double 10 times in 36 years as follows: $2, $4, $8, $16, $32, $64, $128, $256, $512, and finally $1,024. Therefore, my 20% return, which is double the 10% return, does not just double the amount of money I will earn, it doubles the number of times my money doubles over the same time frame.
For purposes of this article, our experience and research has shown that this effect begins to change the fair value PE ratio at the cross-over point starting at 15% growth. However, I would add as an aside that once growth exceeds 30%, the fair value PE ratio tops out. This concept would require another article to be fully developed, therefore I respectfully introduce it here in order to provide the beginning of insight into fair valuation at higher growth rates.
Ross Stores Inc (ROST) 17.2% Earnings Growth
Our seventh example, Ross Stores, Inc. (NASDAQ:ROST), has a historical earnings growth rate of 17.2%. Now we are getting far enough above our average fair value PE ratio of 15 where we can see how faster growth finally warrants a higher PE ratio. The orange line on the Ross Stores’ graph represents a PE ratio of 17.2 with is equal to its earnings growth rate. With a close examination of the earnings and price relationship, it is clear that a 17.2 PE ratio represents a good proxy for fair value for Ross Stores Inc. More simply stated, it would have been historically sound to invest in Ross Stores at a PE of 17.
LKQ Corp (LKQ) 27.3% Earnings Growth
My final example reviews LKQ Corporation (NASDAQ:LKQ), a recycler of auto parts, with a historical earnings growth rate of 27.3%. For the first five years in this example, we see that the fair value PE ratio was the equivalent of the 27.3% earnings growth rate. Then the great recession lowered the PE ratio to the normal PE of 22.1. Nevertheless, this chart reveals that LKQ’s earnings growth rate has been significantly above 15%, and therefore, has commanded a significantly higher valuation. In other words, this stock could never have been bought at our 15 PE ratio, because the stock has never traded at such a low valuation thanks to its high growth.
