[ Growth Valuations ]
Hi Al,
Thanks for being patient on the valuation question. I use the basic premise that an approximate "fair value" for a stock is one with a P/E ratio that is in line with its future projected growth rate. If it's going to grow by 20%, then a P/E of 20 would be a rough approximation of a "fair value" for that issue.
With this in mind, it becomes important to understand what the projected earnings are for future periods, and the relative position of the current quarter to the company's fiscal year.
Let's say a company is projected to have in 1998 cumulative earnings of $1.35 per share, with a Trailing 12 month EPS of $1.12, and earnings are growing by 20.5%. Also, we know from analyst projections that in 1999, the company will be expected to grow earnings by another 20%, for a cumulative per share earnings of $1.62. From this data, I can roughly project an annualized growth rate from the first quarter of 1998 to the last quarter of 1999. From that growth rate, I can look ahead and assign a fair P/E multiple to that company.
The reliability of the projections depend of course on the analysts who create them, the company's history of meeting or exceeding estimates, and various economic developments.
This brings me to another subject that I wanted to touch upon:
Very often, a not-too-knowledgeable investor will scoop up shares of a company for the sole reason that it has a depressed P/E ratio. He or she might think, "Wow! I'm getting a stock for only 7 times earnings! What a steal!" What that poor fellow or fellow-ette doesn't realize is that the company had lost, and had been continuing to lose, major contracts to more nimble companies who have been outflanking the company in every category. Where is the growth? It could very well turn out to be 0%, or even negative. Where's the value in all of that?
The important point here is that one needs to understand the context under which the company is experiencing a low P/E ratio. Quite often, companies will have depressed P/E ratios because their projected earnings growth is either null or even negative. What we need is a reference point to establish whether or not that P/E is "cheap" or "expensive." And what can we use? The projected growth rate! Putting the two side by side, we can judge whether or not a stock is cheap relative to its growth rate.
To make an analogy, let's look at two drivers: one is driving 45 miles an hour, and one is driving at 65 miles per hour. You may think that the 45 MPH driver is slow, and that the 65 MPH driver is fast, but you need to look at the context in which they are driving. If the 45 MPH driver is doing that in a residential zone, you know that he or she is going way too fast for one's safety. Also, if that 65 MPH driver is doing that on the Autobahn (the German expressway), then he better get out of the way for other drivers who are zooming past 100 MPH.
The point here is that the entire context must be understood! Just having a low P/E ratio does not mean that the stock is a good value. We need to understand the P/E relative to its future growth rate. If you don't, you can buy a stock that's figuratively going 65 MPH on the Autobahn. That's not a good value.
Hope this helped.
Regards,
Rainier |
