The business and shareholder results for Visa (NYSE:V) in its brief public history have been nothing short of spectacular. Earnings-per-share of around $0.50 back in 2008 are now anticipated to be closer to $3. The dividend is five times what it was back in 2009, and it still only makes up a fifth or so of profits. The net profit margin is more than solid. And as a result of the fast growing business and expanding earnings multiple the investor of 2008 through 2015 would have seen compound gains on the magnitude of 29% per year.
Of course today's investor does not benefit from yesterday's growth. Well, they do and they don't. An investor does benefit from superior past performance in that a company has the propensity to remain as an excellent business. However, an investor does not benefit in that there's nothing requiring this performance to be repeated and indeed as a result of the "carry through effect" it could very well be more difficult to formulate solid returns moving forward.
Today's investor, or prospective investor, still has a lot to like about the business. The balance sheet remains in superb shape, the excess funds are still being created and it turns out people still like to swipe a plastic card. All bode well for the future profits of the firm.
So let's try to think about what shares could possibly be worth in the future. Analysts' estimates for Visa's intermediate-term growth that I have seen have ranged anywhere from 11% to 17%. Given the company's previous record, this appears conceivable. Let's use say 14%, keeping in mind that this is merely a baseline.
Ideally you'd like to think much longer-term, but for the sake of illustration we'll keep it simple and use a five-year time horizon. After five years of growth at 14%, Visa could be earning $5 per share. Next up is figuring out a reasonable valuation multiple.
Over the past eight years Visa's average earnings multiple has been in the low-20's (22 or 23). This was highlighted by a few years under 20 (mainly 2011) along with today's number which happens to be closer to 30. It's certainly conceivable that investors would be willing to continue to pay a "premium" for a premium company growing at a fast rate. Then again, it can also be prudent to work with a bit more cautious assumptions.
Even when Visa grew earnings-per-share by 27% and 24% in 2011 and 2012, shares still traded below 20 times earnings. In fact, a lower rather than higher valuation was commanded for a time. So while a higher multiple is always possible, there's nothing preventing shares from trading at a lower value either. Let's see what a future multiple of 22 would look like.
This would imply a future share price after five years of about $110. Future dividend growth is unknown, but if were to increase by 20% annually over the half decade period you'd still only be thinking about paying out about a third of the company's profits as cash. This could add $5 per share or so, giving you a total expected value of about $115.
In my view this is a crucial first step. A lot of people look at the share price first and then become "anchored" to this value. If you see a price of Y, everything that you do thereafter will be compared to that number. The process above is thinking about a reasonable baseline and then working from there.
The final step to get sense of what you might be willing to pay for a share is to discount that future value back to today. You're starting point is that a share of Visa might provide $115 worth of value in the next half decade. From here you have to determine a rate of return that you'd be happy with. Naturally this varies from investor to investor and is based largely on your personal ambitions. I'll keep the example going and see what an expected return of 9% would require.
If you discount $115 by 9% you come to a price of about $75. Next you'd like to think about a range of possibilities, but I'll cut to the punch line before circling back.
Now we're ready to look at what the market happens to be offering. As I write this shares of Visa are trading hands around $78, so just a bit above what you might deem "reasonable" based on the assumptions given above. Of course its paramount to remember that this is not an absolute. You're going to get a very specific number - say $74.73 - when you start working through the process outlined above. Yet this is certainly not to suggest that $74.73 is fair and $75 is no good. Or that $78 or $85 or $95 can't build wealth. The concept is to simply get a feel for what your assumptions imply.
Let's make two more adjustments just to show you how finicky the process can be, and why you need to remain cognizant of leaving ample margin for error.
In the above illustration I used a discount rate of 9%. Yet this certainly isn't to suggest that it is the only rate or correct rate to use. Here's what the same business and share assumptions equate to with varying return requirements:
6% = $86
7% = $82
8% = $78
9% = $75
10% = $71
11% = $68
12% = $65
13% = $62
Based on that information, presuming that your starting assumptions are reasonable, you could indicate that a "fair" price to pay for Visa is anywhere between $62 and $86. That's a fairly large range. Incidentally, this sort of mirrors the concept of Morningstar in that this service provides an exact "fair value" estimate but gives a "buy" and "sell" range spanning 60% (30% above and 30% below). It's evident that this is more of a guesstimate than an exact, down-to-the-penny exercise. It's not a math problem, it's a wealth building solution.
By the way, I thought it'd be fun to check out Morningstar after I completed the above exercise (it was). Morningstar has a "fair value estimate" of $104. With a range of $72.80 ("consider buy") all the way up to $140.40 ("consider sell"). So you can see that it even for people that do this all day, that's a very wide range.
Perhaps just as interesting is that Morningstar recently increased its "fair value estimate" from $71 up to $104, which was based on "34.5 times" their 2017 earnings per share estimate. I'm not sure how you pick 34.5 instead 34 or 35 (or 25 for that matter), but this underscores the notion of being aware of your assumptions.
While we created a wide range of potential "fair values" in the example above by simply by changing the discount rate, there are way more possibilities. Instead of changing the discount rate (we'll leave that at 9% for the below demonstration), you could think about varying P/E ratios and growth rates:
In the above table I looked at future growth rates ranging from 6% up to 18% per year for the next five years. I grew the dividend payment in line with earnings, and then used an ending P/E ratio ranging from between 16 and 30. Finally, I discounted that back today using a 9% required return.
I'll make it straightforward: the above values represent the price that you need in order to generate 9% annual returns. So as a for instance, if Visa grew earnings-per-share by 10% each year and had a future earnings multiple of 24, you would need today's price to be $68 to generate 9% annual returns. This isn't perfect either, but it demonstrates the process well.
As you can see, our beginning assumptions of 14% growth and a future multiple of 22 represent a "fair" price of $75. In order for you to see a return of 9% or greater with a higher price, you would need either faster growth or a higher ending valuation multiple. (The dividend could also add here if it grew faster than earnings, but so far this payout has not been substantial.)
So depending on your view, a "fair" price to pay for Visa is apt to be anywhere between say $40 to $120. I know that's not going to be a crowd favorite as far as answers go, but the idea is that it's largely based on your assumptions. You can begin to narrow it down (as we did to start) and then suggest something along these lines: "as a baseline a share price around $75 seems reasonable, although I acknowledge that there is a ton of variability associated with this number depending on a variety of factors."
And by the way, the above table is only using one discount rate. You could create a separate table for every discount rate that you want to look at.
This is why I think it's ludicrous to make investing decisions based on a slightly higher or lower expected value. Recently an analyst came out with a price target for Wells Fargo (NYSE:WFC) of $45 as compared to a closing price around $49, and indicated that it must then be a "sell." That's great, the analyst could be right about the "true" value of the security.
Yet this line of thinking fails to take into consideration the above. While $45 may be your estimate, you must acknowledge a very wide margin for error. Your growth rate, dividend, earnings multiple or discount rate could all off. Even small changes make a big difference. You're going to come up with a very specific number, the trick is to treat this as a "range of reasonableness" instead of something that's already been set in stone.
It short, determining the "fair" value for Visa, or the price that you "ought to pay," is both unknown and largely personal. Investors have different goals, so the acceptable range of returns is naturally going to be different as well. Moreover, it's important to remain cognizant of the idea that you're making guesses about the future, so it's not going to be perfect (far from it). The idea is to come up with a reasonable (perhaps cautious) baseline and then determine a wide range of possibilities. This gives you a basic idea of what a security might be worth to you, but does not simultaneously "lock you in" to a down-to-the-penny estimate.
Disclosure: I am/we are long WFC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.