Many of my stocks reached all-time-highs over the past few months. When I purchase my stocks, I usually expect a decent current yield in the 2% - 4% range, followed by a P/E of 15 - 20, and growth in earnings and dividends that averages at least 6%/annually. So far, it has averaged 7% - 10%. As a result, short-term fluctuations in the price of a company which I purchase for say $100/share today which yields 3% and trades at a P/E of 16 would not bother me too much. I would expect such a company to realistically trade at about $200/share in a decade or so, still yield approximately 3% and trade at a P/E of about 16. Over that decade, it could trade as high as 25 times earnings and as low as 10 times earnings. The only difference is that its earnings and dividends have doubled over the period. My whole premise of the idea that I won't sell even at a 1,000% gain is based on this mental model.
Of course, in real life, things never progress in a linear fashion. If you looked at P/E ratios of companies like Wal-Mart (WMT) or Coca-Cola (KO) over the past 10 - 15 years, you would not be surprised to see them over 30 in not one, but at least several occasions. Over the past four years, most of the companies I have usually added to were the likes of Colgate-Palmolive (CL), Johnson & Johnson (JNJ) and Kimberly-Clark (KMB). Right now many of these companies look very overvalued, which is pretty scary. I actually isolated the following companies, whose P/E ratios per Yahoo Finance exceeded 20. I then excluded MLPs and REITs for which earnings per share and P/E ratios do not provide comparable results.
Being the lover of annual reports, and digging around data, I went through this list searching for the answer of an obvious question. The question running through my mind was whether it still made sense for me to hold on to these companies. Now, I am not a die-hard buy and hold despite everything type of investor, and a crazy valuation could lead me to sell an otherwise fantastic company. This of course depends on each particular situation. However, I do believe that taking small profits on the few amazing ideas I might be lucky enough to stumble upon in my lifetime would probably be very detrimental to my finances. I could sit out temporary overvaluations in securities, for which future growth could compensate me well for holding on during a moderate level of craziness. Craziness for a company like Brown-Forman (BF.B) (BF.A) could be a P/E above 30, whereas for a company like Con Edison (ED) craziness could be anything above 18 - 20 times earnings.
However, in my studies of investing, I have learned to dig for information. Most of the information on earnings per share from sources like Yahoo Finance might be abnormally low, because certain one-time adjustments have reduced it. My next step would be to look at analyst estimates for the current year and the next one, coupled with digging around press releases from the company, in order to evaluate whether those estimates have any merit.
Just by looking at P/E ratios, the stocks in the table look very overvalued. However, if you look at forward earnings, only a couple of those look somewhat overvalued.
For example, looking at Johnson & Johnson, it looks terribly overvalued at 23 times earnings. However, by applying forward EPS of $5.41/share, the stock looks much more reasonably priced. While not included on this table, Kimberly-Clark looks expensive at 21.06 times earnings and EPS of $4.60. But based on 2013 forward earnings of $5.73/share, it looks cheap at 16.90 times forward earnings. Of course, if analysts are overly optimistic on this company and actual earnings are significantly less, then Johnson & Johnson would be overpriced today.
For those companies that still look overvalued, I am going another step. I estimate what the company is going to earn in a decade, then estimate the total in dividends I will receive over the next decade and then slap a P/E multiple for this time in 2023. My estimates are conservative in regard to growth, although not as conservative in regards to multiples.
For example, Brown-Forman is expected to earn $2.70 in 2013. I believe that by 2023, it could easily earn $6/share and trade at a P/E of 20. In addition, I would expect that Brown-Forman would pay its shareholders approximately $20 -$25/share over the next decade. This means that investors paying $70/share today might end up doubling their money in a decade. This translates into a return of approximately 7%/year. Those of you reading this article in 2023 would likely use this article as an example of why people should never make predictions. Either way, it is my best case based upon widely available information on consumption on liquor worldwide, historical growth rates, and assumptions for the future revenues, earnings and dividends.
For Automated Data Processing (ADP), I like the fact that it offers business services such as payroll processing to small and medium sized businesses. These businesses outsource certain functions like payroll to ADP, which benefits from scale of transactions processing, constant improvement in technology and depreciation in technology equipment prices. But most importantly, ADP benefits from building and maintaining relationships with businesses, which would be less likely to switch processors just to save a few bucks. Over the past decade, EPS grew by 5%/year. If we project this growth forward, this means ADP would likely earn $4.82/share in 2023, which at a P/E of 20 translates into $96.40/share. If dividends also grow at 5%/year, this means that an investor can expect to receive $23 in dividends over the next decade. This translates into a total return of about 6%/year. Check my analysis of ADP.
I purchased Visa (V) in 2011 because I liked the story about the credit card processing business, the fact that there are only two major companies in the game, and the opportunity behind growth of cashless transactions worldwide. These were the reasons why I initiated a position in the stock despite the fact that the company has only been publicly traded since 2008. I expect Visa to either double or triple earnings per share over the next decade. This could translate in EPS ranging from $15 to $20 by 2023. At a P/E of 20, this translates into $300 - $400/share. I expect dividends to increase at the high end of these projections, and triple by 2023. Thus, I wouldn't be surprised if Visa shareholders receive about $25 in dividends over the next decade, with annual dividends reaching $4/share that year.
The return assumptions for the three stocks above, ignoring dividend reinvestment, which would likely increase the annual returns slightly.
Nucor (NUE) is the odd one out, as it is a cyclical stock. The demand for steel fluctuates with the cycles in the economy, meaning that profits and revenues are highest at the peak of the cycle, and very depressed at the trough. This is why cyclical companies usually appear overvalued when their stock prices are low, and cheap when their prices are high. During the last boom, Nucor earned $5.98/share in 2008. In addition, the company kept raising its regular dividend even during the lean years after that. The thing that appeals to me is the fact that during the boom years through 2007 - 2008, Nucor paid special dividends every quarter to shareholders. Management was smart enough to realize that this boom in profits would likely be a short term event, yet they still wanted to keep the streak of dividend increases going and reward long-term shareholders as well. This is why if you simply look at trends in dividends per share, you might see a decrease in 2008. However, the regular dividend amount was never cut, but actually increased. If the US economy keeps expanding, we might see growth in earnings per share, and a lot of special dividends from Nucor. This is the one stock where I cannot provide a 10-year guidance of earnings and dividends, but would likely hold on to either way. You get a stable and slowly rising dividend payment, plus a "lottery type" opportunity for special dividends when times are really good. Check my analysis of Nucor.
As a long-term investor, my holding period is in years for some stocks that don't work out as well, to decades for the ones that keep delivering results over and over again. As such, it was helpful for me to go over my positions above. Overall, when I looked at what seemed to be the most overvalued stocks in my portfolios, I found out that there is nothing to be scared about. Some of the valuations were high either because of one-time events depressing earnings per share and in those situations forward earnings per share showed a more reasonable valuation. In other scenarios, I reassessed the reason as to why I held on to certain stocks, and whether it still made sense to hold on to them.