Seeking Alpha
Chuck Carnevale, FAST Graphs (1,015 clicks)
Long/short equity, growth, dividend growth investing
Profile| Send Message| ()  

There are two critical attributes that prudent investors should consider before investing in stocks. Furthermore, these same two attributes can be used to calculate a reasonable expectation of future returns. These two attributes are valuation and the rate of change of earnings growth. Valuation indicates whether or not the company's current earnings power compensates investors for the risk they take, while the company's future rate of change of earnings growth will be the driver of future returns.

We believe these are very important concepts for several reasons. First of all, you can make an investment at fair value into a low or slow growth company, and still not generate a high rate of return. On the other hand, there is typically less risk associated with achieving that return because achieving a low rate of earnings growth is easier to do. Conversely, you could overpay, perhaps significantly so, for a very powerful or fast-growth stock and still earn a high rate of return, because of the power of compounding.

However, by overpaying, you are taking on more risk than you should. First of all, the probability of a company achieving a very high rate of growth is very low, and second, over the long-term, it's virtually a given that the price will return to fair value. Therefore, you won't be able to harvest the full measure of the company's growth achievement. More simply stated, the probability of a future P/E contraction is very high. The effect is a lower rate of return than deserved, while illogically taking a higher level of risk than necessary to obtain the lower return.

To summarize, if a company grows fast enough, then future earnings growth can overcome a high beginning valuation. However, the risk taken to achieve it is amplified by the high valuation. Conversely, if you come across an opportunity to buy a stock at a very low valuation, even a low growth company, your return potential is greatly enhanced while simultaneously reducing your risk.

On the other hand, overpaying for a slow grower (for example, a typical utility stock) destroys your return potential while simultaneously turning what might normally be a low-risk investment into a high-risk one. In the same vein, if you can find a slow grower that is significantly undervalued, you could generate a high return and arguably achieve it at very low risk.

Valuation Demystified

Fair valuation alone does not automatically indicate a high future return or even an adequate one. In truth, valuation is a relative concept that becomes relevant to future return only when considered in conjunction with future growth.Valuation unto itself is most relevant in the context of current time. In other words, valuation itself applies predominantly to current fundamentals. Consequently, we see valuation more as a measurement of soundness than as a rate of return expectation.

As a result, both a moderately fast-growing stock and a very slow-growing one can command the same valuation in current time. However, given fair valuation for both, the one that grows faster offers a higher future return. This concept can apply to all stock classes, including dividend and non-dividend paying stocks. Simply stated, valuation is about prudent behavior and mitigating risk.

To illustrate this more clearly, let's consider the most common valuation measurement, the P/E ratio. P/E ratio is more than a mere statistical inference. It is a relevant measurement of valuation that represents the appropriate compensation for the amount of risk an investor is currently assuming. The key to understanding this is to recognize the P/E ratio as a measurement of the earnings yield being offering by the investment.

To put this into perspective, consider that the long-term average P/E ratio of the S&P 500 has been, depending on the time frame being measured, somewhere between 14 to 16 times earnings (S&P 500 average P/E 14 - 16). Jeremy Siegel, professor of finance at the Wharton School at the University of Pennsylvania has written that stocks have returned an average of 6.5% to 7% per year, after inflation, over the last 200 years. For simplicity's sake, we are going to hang our hats on the historical average S&P 500 P/E ratio of 15.

Answering the important question -- why a P/E ratio of 15 is common over such a long period of time, is more critical than simply knowing the number. So let's analyze what P/E ratios of 14 - 16 translate to in terms of rate of return calculations. What we discover is that a P/E ratio of 15 represents a reasonable and attractive rate of return of approximately 6% to 7%. These returns have, historically been achieved (the long-term stock market average), and therefore, are logically considered acceptable and achievable.

To clarify, let's actually calculate the rate of return (earnings yield) that a P/E of 14, 15 or 16 represents. To determine the earnings yield, simply reverse the P/E ratio (Price divided by Earnings) and calculate the E/P ratio (Earnings divided by Price). Therefore, we learn that a P/E ratio of 14 equals an earnings yield of 7.1%, a P/E ratio of 15 equals an earnings yield of 6.66%, and a PE ratio of 16 equals an earnings yield of 6.25%. Therefore, we learn through wisdom, that it is no coincidence that these calculations coincide almost perfectly with Professor Jeremy Siegel's historical statistic, which shows average stock market returns of 6.5% to 7%.

In other words, an average stock market P/E of approximately 15 (14-16) is rational and makes economic sense because it represents an appropriate yield on investment, which is why it is so commonly applied to most stock valuations. However, how do we apply this practically in the real world?

Testing the Fair Value 15 PE Ratio Hypothesis

To test the fair value P/E ratio of 15, we will utilize the earnings and price correlated Fundamentals Analyzer Software Tool - F.A.S.T. Graphs™. This powerful "tool to think with" utilizes widely accepted formulas for valuing a business. Using these formulas,we can calculate appropriate valuations in the form of P/E ratios.

Interestingly, these formulas tend to calculate the fair value P/E ratio to be approximately 15 for companies whose earnings growth has historically averaged 3% to 15% per annum. Companies whose growth is below 3% will calculate out at P/E ratios slightly less than 15. For very fast growing companies (above 15%), a different formula that calculates higher P/E ratios applies, and will be presented later. This supports the 200-year 6.5% to 7% yield that Professor Jeremy Siegel reported. (Remember, a P/E of 15 equals an earnings yield of 6.66%).

Once we have calculated the fair value P/E ratio, we can overlay monthly closing stock prices onto the graphs to determine if there is a strong price and earnings correlation. If the formulas are valid, then we should see a very close association between earnings and stock price relative to a P/E ratio of 15 over time.

The following four earnings and price correlated graphs illustrate how the market has historically valued companies that possess varying growth rates that range within the 3% to 15% growth category at a P/E of 15. Note that each of these samples shows that the calculated P/E (the orange line) and the normal P/E historically applied by the market (dark blue line) are virtually the same, or very close.

SCANA Corp (SCG): A Low Growth Regulated Utility

Our first example plots SCANA Corp., whose earnings growth rate has averaged only 3.3% per annum. Since we believe that fair valuation is a function of the earnings yield represented by "current earnings," purchasing a company at fair valuation implies that the investor is making a sound financial decision. However, as previously stated, this does not necessarily guarantee a high future rate of return. As we will illustrate in Part 2 of this article, that will be determined by the company's future earnings growth rate.

The orange line on the following graph represents our fair value P/E ratio of 15 applied to SCANA Corp.'s historical earnings since calendar year 1998. Every point on the orange line equals a PE ratio of 15. The Graham Dodd Formula was used to calculate the fair value P/E ratio of 15 and is expressed to the right of the graph in orange letters -- GDF x 15. According to our thesis, if this is truly a fair value P/E ratio, then price should track the orange line very closely over time when we apply the stock price overlay.

click images to enlarge

The next graph overlays monthly closing stock prices with our orange earnings justified valuation line. Moreover, we've added two additional important valuation metrics. The light blue shaded area expresses dividends paid out of earnings, which are represented by the green shaded area. The dark blue line represents our algorithm calculating the normal P/E ratio that the market has historically applied to this business over this time period.

As you can see, the black price line tracks the orange earnings justified valuation line (P/E = 15) almost perfectly. The normal P/E ratio (14.4) is also almost a perfect match, indicating that the market has historically appraised this company at approximately 15 times earnings. Furthermore, during the short-term periods when price temporarily deviates from earnings, we see that it soon returns. Therefore, we discover in this example that fair valuation exists any time the stock is trading at a P/E ratio of 15 or below. (Note: Once again, the rate of return that this produces is a different matter that we will explain in Part 2 of this article).

OGE Energy Corp. (OGE): Another Utility with Slightly Higher Growth

Our second example, OGE Energy Corp, differs from our first only in that its earnings growth rate since 1998 has averaged over 5% per annum. Nevertheless, we once again discover that the P/E ratio of 15 represents a strong proxy for this company's valuation. During the short intervals when price deviates from fair value P/E of 15, it doesn't take long for price to move back into alignment with earnings.

Furthermore, during this time frame, there have been almost no incidences of overvaluation with either of these two examples. However, we see in both cases that when the P/E ratio falls substantially below our P/E 15 standard, the opportunity clearly manifests for higher rewards at significantly lower risk.

Wolverine World Wide (WWW): A Faster Growing Global Marketer of Footwear

Wolverine World Wide moves farther up the growth chain, with average earnings of 9.4% per annum. Nonetheless, we can again see the strong relationship and close correlation between stock price and earnings over the long run. Perhaps due to the faster earnings growth rate, we do see several periods where the company's P/E ratio has deviated significantly above the 15 standard, indicating overvaluation. Nevertheless, just as we saw with our first two examples, stock price inevitably and soon moves back into alignment with earnings.

Inter Parfums, Inc. (IPAR): Develops, Manufactures and Distributes Prestige Perfumes

Our final example, Inter Parfums, Inc., is an above-average growing small cap that validates our P/E 15 standard, but with a twist. Small-cap companies tend to carry greater risk than larger-cap companies. As a result, it is not uncommon to see, as we do with Inter Parfums, Inc., an earnings and price correlated graphic with wilder price swings.

On the other hand, we believe the following graphic clearly validates the thesis of fair valuation. The P/E 15 principle continues to apply over the long run. More directly stated, price does track earnings, albeit with violently volatile price swings in between. But most importantly, despite the price gyrations, stock price continues to quickly and inevitably revert to the fair value P/E ratio mean of 15.

Summary and Conclusions

Our focus has been on the principle of fair valuation, or as we like to call it -- True Worth™. We believe that by understanding and accepting the idea that fair valuation is primarily a metric of soundness, it also lays the foundation for determining future returns from a common stock investment. However, as we will explain in Part 2 of this two-part series, valuation is a relative measurement. Therefore, when viewed in isolation, it does not provide an accurate future return calculator.

To calculate future returns with a reasonable degree of accuracy, we must consider valuation as it relates to earnings growth. Here, we have provided evidence that fair valuation calculates out to be very similar for companies generating earnings growth of 3% to 15% per year. Our thesis is that fair valuation is, first and foremost, a function of a stock's current earnings yield. This is why companies with different earnings growth rates will command similar, if not identical, current valuations. However, as we will explore in Part 2,when growth becomes very fast (above 15%), a higher valuation becomes justified thanks to the power of compounding

But perhaps most importantly, we intend to demonstrate in Part 2 how common stock investors can use the principle of valuation in conjunction with the company's expected future earnings growth rate to determine reasonable future rate of return expectations. We believe these are critical components for investors to master. When valuation is understood and considered in conjunction with future earnings growth, risk assessments also become more clear and accurate. Consequently, not only can investors gain a better idea of the rate of return they can expect, they can also ascertain how much risk they are taking on to generate it. As a result, they can make smarter, sounder and more profitable buy, sell and hold decisions.

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.

Source: How To Know What Rate Of Return To Expect From Your Stocks: Part 1