In the investing world using P/E ratios is a fairly common way to gauge the relative valuation of a given security. Naturally it's not perfect, but it does provide you with a baseline to think about a company. Even if the past marks are not relevant today, it can be helpful to learn why that may be the case.
What's interesting, in my view, is that while a given earnings multiple may seem similar - say a historical average of 15 times earnings for Consolidated Edison (NYSE:ED) and 15 times earnings for Kroger (NYSE:KR) - these marks may not be as equal as they seem.
It's not enough to look at two P/E ratios for separate securities and start to draw a conclusion. Instead, it's imperative to think about how these valuations could interact with the current value through time. I'll give you an example to demonstrate what I mean.
You could dig up actual securities with these characteristics, but for our purposes a hypothetical situation works well. Let's imagine that you have three securities with the same average P/E ratios and starting P/E ratios. The difference is the growth rate of each company. Here's the basic outline:
From a cursory glance you might see that all three securities have the same P/E ratio and suppose that the valuation propositions are similar. This doesn't have to hold. You can have a company like Consolidated Edison growing in the low single digits as compared to say Cracker Barrel (NASDAQ:CBRL) growing close to 10% per year. Both have average P/E ratios around 15 over the long-term, but the characteristics of the businesses are vastly different.
Part of this difference is compensated in the way of a larger starting dividend yield. The slower growing company often pays out more of its earnings to shareholders. Given the same valuation and a higher payout ratio, this means that the dividend yield must be higher. So in the above example you can see that the "slow grower" in this case "A" starts with a 3.8% dividend yield as compared to just 1.2% for the "fast grower" that is the hypothetical "C." This is a very realistic occurrence in practice.
However, that's not to suggest that the higher starting dividend yield makes up for everything. It makes up for part of the lack of growth, but part of it may never be made up.
Let's continue with the example to demonstrate what I mean. All three securities start with the same P/E ratio and end with the same P/E ratio. In addition, the slower the growth in this case, the more you'd anticipate collecting in dividends. Yet this alone is not enough to compensate today's investor.
In the first scenario - "A" - you'd anticipate earnings to be about 22% higher over the next decade. Yet due to the P/E ratio going from 17 back down to 15, the share price would only be about 7.5% higher. Your total gain from holding the security would be about 4.2% per annum (including dividends), turning a $10,000 starting investment into $15,000 after 10 years.
In the second scenario - "B" - you would anticipate earnings to be about 80% higher, but the share price to be up "only" 60% due to the decrease in the valuation multiple. You would collect less dividends than the first example, but the growth rate would make up for this. In total you would expect an annualized gain of about 6.3%, good enough to turn a starting $10,000 investment into $18,500 or so.
With the third alternative - "C" - earnings would be about 160% higher while the share price could be 130% greater, once again showing the effect of a contracting earnings multiple. For this scenario you would collect the lowest amount of dividends, but the total return would be the highest - coming in at 9.2% per year, turning a $10,000 investment into $24,000.
It seems obvious that a faster growing security with the same start and end valuation multiples would be the "winner," and really it is. However, there is an important takeaway in my view: the slower a company happens to be growing, the more diligent you have to be on getting the valuation correct.
I'll give you a real life example, continuing with Consolidated Edison. If you purchased shares of the company at the end of 1998 and held through 2010, you would have seen earnings-per-share increase by a total of 11%. Yet the share price declined over that period, due to the earnings multiple going from around 17 down closer to 14. Due to the dividend, your annualized return would have been around 3.2%.
If instead of purchasing shares in 1998, you had waited until 1999 when shares were exchanging hands closer to 11 times earnings, your annual return would have been closer to 7.3%. This doesn't mean that it always pays to wait (far from it). Instead, it simply demonstrates the importance of valuation for slow growing companies.
With something like Visa (NYSE:V) you can buy today and "grow out of" paying a valuation that is perhaps a bit too rich. The same thing goes with a Coca-Cola (NYSE:KO) or Johnson & Johnson (NYSE:JNJ). Obviously you'd prefer to buy shares at 15 times earnings, but paying 17 times isn't exactly the worst thing in the world. With utilities or other slow growers, this luxury does not exist in the same way. You'd still expect growth, just not enough to justify getting on the wrong side of the valuation.
Now some might suggest that this is great in theory, but not applicable in practice. The higher the perceived growth rate, often the higher the valuation multiple as well. However, I'd like to make a couple of points. First, this doesn't always have to hold. As indicated above, companies like Kroger or Cracker Barrel could have the same historical earnings multiple, but provide much greater growth. It's harder to see today with both securities trading at higher multiples, but a few years ago it was especially evident.
The second thing to consider is that even in this circumstance the potential returns could still favor the faster growing companies. I'll show you what I mean:
The first column "A" is precisely as it was above, I didn't change anything there. For the other two scenarios I kept the growth rate the same, but increased the average and starting P/E ratios (simultaneously decreasing the starting yield).
So I presumed that the second option "B" started at a P/E ratio of 19 and declined to 16, while option "C" went from 22 down to 18. These are more forceful swings than before. Yet check out the last row of "total return." The faster growing securities still would provide an edge. So even when you adjust for relative valuation, the idea remains.
You could look at it one of two ways. Either "paying up" for faster growing securities could be worth it. Or alternatively, being mindful of paying a reasonable price for slower growing companies ought to be in the forefront of your investing thought.
In order for the faster growing securities to be equal to the slow growth scenario, their respective earnings multiples would have to fall to 12 or 13. Alternatively, in order for the slower growing option to match the returns by the other two, you would likely need to purchase shares with a starting earnings multiple in the 12 to 15 range.
In short, the objective of paying a "reasonable" price should always be on your mind. This allows your investment to capture the business performance and perhaps even more. And it should be further noted that this objective requires even more discipline as the anticipated growth rate slows down. "Paying up" for a company that's growing by 10% can work out fine, even if you experience some earnings multiple compression down the line. Alternatively, your returns could be quite lackluster if you tried the same thing with a company that is only growing by a percent or three.
Disclosure: I am/we are long JNJ, KO. 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.