No matter how ones says that trailing PE ratios are irrelevant, it just doesn't ring true with most people. People recall the frequent warnings they hear about the danger of high PE ratios. Supporters of a company with a high PE ratio are imagined to endlessly repeat "This time it is different" as if they are Alice in Wonderland.
OK, here is the offer. You can buy WIND at $24 with a trailing PE ratio of 55.8 or you can buy INTS at $13 with a trailing PE ratio of 28.3, or at about « the price of WIND on a trailing PE ratio basis.
Based on current analysts' projections (not mine), the WIND investment will earn an acceptable return as long as WIND grows future earnings at a 22.9% clip for the subsequent five years. The INTS investment will earn an acceptable return, based on analysts projections, as long as INTS grows future earnings at a 19.2% clip for five years. I find it interesting that WIND is more expensive than INTS, but only by the requirement that it grow earnings by an additional 3.7% per year. In other words, it is not twice as expensive as implied by trailing PE ratios.
Which investment is most likely to disappoint and under-perform the respective minimally acceptable growth rate? This should be easy to determine since WIND is sailing along, as confirmed by its market price, and INTS is defensively arguing that it will succeed in getting a critical new product to market and that costs really will be contained in the future, also confirmed by its recent tanking? [Put your answer here]
Extraordinary profits will accrue over a five or six year time-frame if the company in which you invest grows earnings faster than the minimally acceptable rates. For example, should WIND consistently grow earnings at 40%, which is what the analysts claim will happen, then you will earn an acceptable return plus an additional tripling of the present value of your investment. Should WIND consistently grow earnings at 60%, which is the expected outcome of I2O, NC, wireless, etc., then your bonus will be a 10 bagger. Of course, the bonus is similar if INTS performs well.
Which investment is most likely to exceed the minimally acceptable growth rate the most, WIND (22.9%) or INTS (19.2%)? [Put your answer here]
If your answer is the same in both instances, then that is the economically preferable choice for you.
These results hold mathematically, and are not subject to normal whims of the market. As long as either company grows earnings as assumed in any of the scenarios, the appropriate present value of the future price will obtain. (Since I'm not selling anything, I don't have to include all the fine print concerning detailed assumptions.)
I like this way of valuing investments because of the following:
(1) It forces the investor to look at what he is buying - earnings growth - not what he is not buying - past performance.
(2) It often shows that minimally acceptable growth rate assumptions for companies with hugely different trailing PE ratios are practically comparable.
(3) It enables the investor to use the market price to confirm the reasonableness of growth assumptions. An investor seeking low trailing PE ratios can't listen to what the market is trying to say about a company. An investor who translates the market price into an equivalent growth rate, can grasp the meaning of a high price, and the extent to which the market likes the prospects for the company. His/her only concern is whether the market has over-stated growth, or has left precious little room for extraordinary profits.
Allen |
