Essence of Value Investing is Soundness Not Rate of Return

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Summary

The following table summarizes our eight examples which are presented in order of highest historical earnings growth to lowest. Although the fair value PE of 15 applies to all the companies below 15% earnings growth, as an indication of soundness, note that the annualized performance of each company closely correlates to its historical earnings growth.

This illustrates our thesis that although all the companies below 15% growth warrant a fair value PE of 15 to be considered sound investments, this does not mean that all of them will produce the same rates of return.  The rate of return will be more a function of each company’s earnings growth rate, assuming that they are bought at the appropriate fair value PE of 15 for growth below 15%, and a PE ratio equal to the earnings growth rate for companies showing above 15% earnings growth.

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Conclusions

The purpose of this article was to illustrate the principles and nuances of fairly valuing common stocks at various growth rates.  Hopefully it also illustrated that valuation is a valid concept that helps determine whether the investment is sound or not.

However, it should also be recognized that fair valuation should always be thought of as a guideline rather than an absolute number.  Furthermore, this does not diminish the value or importance of getting fair valuation right. Possessing a solid understanding of fair valuation is a vital prerequisite to successful common stock investing.  Fair valuation is not meant to be rigidly adhered to.  Instead, it should be thought of as an important tool in the investor’s arsenal assisting them with making sound and successful investments in common stocks.

Disclosure:  Long UTX, ABC, ROST & LKQ at the time of writing.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

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