MORE ON VALUATION
Malcolm and all,
You mentioned that it's sometimes difficult to predict the future growth of a company but it's something we must do to have any incling of fair value. Very true.
Your comment makes me revisit my comments about the forward PEG. For the valuation-challenged, the forward PEG is called that because the E component is the current year's estimated earnings, not the traditional trailing earnings most PEs use. The problem I have with using estimated earnings to determine the PE instead of actual earnings is because the result is that virtually all aspects of the PEG except the price become based on an educated guess at best. Contrast that with the traditional PEG in which the PE is based on actual earnings, resulting in a ratio half based on historical fact and half based on estimated growth.
So........
I hereby amend my comment from yesterday when I wrote that there's nothing wrong with using a forward PEG. I believe it is flawed. Instead, if the traditional historical earnings-based PEG doesn't seem right for you when evaluating a particular type of company such as an established Gorilla still in hypergrowth, consider establishing in your mind that a ratio of 1.5 or 2.0 or whatever is fair value instead of 1.0.
With all this talk about valuation, it's important to appreciate that the only reason to use it is to establish the fair value of a company. However, as much as it might seem like sacriledge to see this coming from my keyboard, it's not necessary to establish fair value. Instead, you can establish the growth in the stock price you're willing to accept and the probability that it will be achieved.
As an example, let's debunk the myth that the fair price of a stock is when its PE is the same as its estimated growth. To do that, we'll assume a company is growing 25% a year and its PE is 50. It's EPS is $1.00 and its stock price is $50. In traditional circles that stock price might be twice as high as it "should" be. But going back to Malcolm's thesis that it is worth examining the PE the stock market will assign a company five years from now, let's also assume that the stock will have a PE of 25 in five years, half of what it is today, due to the expectation that growth in years 6 - 10 is expected to slow to about 15% - 20% annually.
If that lower PE does come to fruition, what will the stock price be in five years? First we have to assume the EPS at that point in time. Because the estimated annual growth in the first five years is 25%, the EPS will have changed from $1.00 to $3.05. The PE at that point time will be 25, resulting in a stock price of about $75.00.
Using those assumptions, we've got a current stock price of $50 that is expected to grow to $75 in five years. That's an 8.5% average annual growth rate.
Most folks around here would not find that an acceptable return on the investment given the current market conditions. So most investors reading this piece would determine that the current price is too high, yet no so-called fair value of the stock was determined.
But let's change the parameter of the future PE from 25 to 75. We'll assume that we know something about the company that causes us to believe that by the time we get to the end of year 5 the growth will begin accellerating, not decellerating. At that point in time the EPS is still $3.05, but because the market is assigning a multiple of 75, we have reason to believe the stock will be about $225. In that scenario, we're asking if we want to buy a stock currently priced at $50 that we think will be $225 in five years. That's a much more appealing annual growth of 35%.
Again, no so-called fair value was determined. Instead, we used criteria about the returns we are willing to accept if we believe the expectations of the company and the market's perception of the company are reasonably predictable.
In the end, we don't really care what the fair value of a stock is. What we want to focus on is what the future value of the stock will be for whatever combination of reasons that cause us to believe our expectation is reasonable. That's because we really only care about the return on our investment. To the extent that determining fair value helps us determine the likelihood of attaining our investment goals, fair value is helpful. But it is not the end-all to all investing practices.
Sorry for the long post and the very crude writing that I didn't take the time to polish. Given the renewed interest in valuations, I hope it's helpful.
--Mike Buckley |
