In the investment world "expensive" is a relative term; no different than you would see in a grocery store. A $5 price tag doesn't tell you much unless you also know what underlying value you'd be receiving in exchange. That amount for a single avocado? Much too high. The same amount for a bag of avocados? Now that might be more interesting.
Furthermore, the quality of an item also has an influence. This concept carries through with investing as well. And one of the most common errors that results is uniformly applying earnings multiples. Two securities could be trading at the exact same price and even exact same valuation. However, this alone does not mean the deals are equal.
It's not enough to see a P/E ratio of 20 or 25 and think "expensive." Likewise seeing a security trade at 8 or 10 times earnings does not automatically denote "cheap." That's half of the equation, but the other side is the underlying quality of a firm and growth prospects.
I'd like to underscore this idea using Nike (NYSE:NKE) as an example.
Back in 1999 Nike was earning a split-adjusted $0.20 or so. The share price got up above $8, equating to a P/E ratio topping out over 40. And here's a time when you could have looked at the security and said "that's too expensive." Indeed, the market as a whole was quite elevated (that may be an understatement) and there would be plenty of opportunities to buy shares at both a lower price and valuation.
Yet here's the thing. An investment at that time - arguably the worst valuation moment in the last few decades - would still have turned in annualized returns on the magnitude of 12% per annum. The P/E ratio compressed by a good amount, but the business performance certainly made up for this. Both earnings and dividends are now 10 times what they were.
And we have seen this time and again. I won't focus on the lower valuations (the returns are even better) but I would like to highlight a few other high points.
In 2002 shares started the year trading at 25 times earnings, which some could think about as being lofty. Yet from that point shares returned nearly 15% per annum.
In 2007 shares got up to 21 times earnings after spending many of the prior year's trading in the 15 to 20 times earnings range. And you could have argued that this price was now "too expensive." Yet from that point investors would have seen 15% annual compound gains through today as well; despite the recession to come.
At the end of 2013 shares got up close to 28 times earnings, a high mark for perhaps the last decade. Yet even here, the security went on to generate 13% annual gains.
A notable exception thus far has been at the end of 2015 when shares got up to 33 times earnings. The results to date have been negative, but I'd also underscore the idea that not much time has passed either. The concept being that even if you see some P/E compression down the line, the above average business results can certainly make up for this eventually.
Which brings us to today. For the last four quarters Nike has reported per share earnings just shy of $2.30. As I write this Nike's share price sits a bit above $56 - equating to a trailing earnings multiple of about 25 times earnings. I'll share a couple of additional items. Nike just announced an $0.18 quarterly dividend which indicates a starting yield of just 1.3%. And earlier this month shares traded hands 7% or so lower than the current quotation.
With those factors in mind, you might think that Nike is now "too expensive." And certainly you may get an opportunity to buy shares at a lower price or valuation in the future. However, just like with the examples highlighted above, I think it's also useful to point out that a security trading at 25 times earnings or with a low 1% dividend yield does not automatically make it a poor investment. You have to think about the potential growth and underlying quality of the business as well.
It depends on where you look, but analysts are presently anticipating intermediate-term growth in the 12% to 15% range for Nike. In the last decade the company has grown per share earnings by about 12% per year - so this expectation is certainly conceivable. Then again, growth gets harder to formulate as the company gets larger, the profit margin has already increased, higher valuation, etc. So instead of 12% or 15% growth, suppose we use 10% - still solid, but a bit less lofty.
If Nike were able to grow earnings by 10% annually, you'd be looking at $5.60 or so in earnings-per-share after a decade. If the dividend were to grow in line with earnings (something that errors perhaps on the cautious side given Nike's low payout ratio) you'd anticipate collecting $12.60 or so in cash payments as well.
Now your future return is going to be determined by the future earnings multiple. Let's survey some possibilities. Shares currently trade around ~25 times earnings, so we'll start there. If shares were to continue to trade at 25 times earnings, you'd have a future price of about $149, a total value of $162 and a compound average annual return of roughly 11% per annum. That would be a perfectly fine result for a security that is currently "too expensive."
Naturally this is not the only possibility. Here's a look at a much wider range of potential outcomes:
Whenever I hear that a security is "too expensive" I like to work through a range of scenarios like the ones depicted above. A lot of analysts are anticipating earnings growth in the 12% to 14% range with a future earnings multiple near today's mark. As you can see in the lower right-hand side of the table, those sorts of assumptions would translate to 13% to 15% annualized gains for Nike, including dividends.
And obviously if you suspect even faster growth or a higher ending earnings multiple, the potential results get better from there. Yet I'm not interested in extrapolating to the sky. Instead, I like to look at lesser scenarios.
The yellow highlighted box indicates the illustration we went through above - namely 10% annual growth and a future earnings multiple about where we sit today. This also could be too lofty. Instead of 25 times earnings and 10% growth, maybe you'd like to scale those expectations back a bit.
The interesting thing to me is that the potential returns still remain quite reasonable on the lower end. Take 8% growth and a future multiple of say 19 - even under those circumstances you could see 6.5% annual gains - enough to improve your investment by nearly 90% over the course of a decade.
This is why it's important to consider what "too expensive" really means. There's a disconnect that can occur when you don't work through the underlying assumptions. Some might see Nike trading at 25 earnings, with 12% or 14% growth expectations and say, "I don't see it, that's too high" and blindly move on. Yet if their anticipation was say 10% growth with a multiple closer to 20, things still could have turned out well.
Now obviously you can have more pessimistic view. For instance, if you think growth will come in around 4% and trade at 14 times earnings, that wouldn't be very attractive. Yet that's sort of the point as well - you have to come up with your expectations and see that they imply. In my view it's not enough to look at Nike's current earnings multiple and suggest it's "too expensive." As we've seen historically, even if you see P/E compression in the future, solid returns could still be obtained.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.