As a matter of fact, I did do a study of this, and I found that the
old rule of thumb (P/E = growth rate) is so far off as to be laughable.
I ran this study after reading The Warren Buffett Way and doing Owner
Earnings analyses similar to the ones in the appendix. After doing
a number of these and getting bored with the repetitive math, it
occurred to me that one could make a table (using Excel, for instance)
that showed growth rates vs. discount rates and giving a relative P/OE
(price to owner earnings ratio). Now, before I show my results, let
me just make this one caveat: To correlate this to P/E, you need to
make an adjustment on a company by company basis, and that only works
if the company maintains a relatively stable ratio between its
earnings and its owner earnings. For instance, my company (TLAB)
usually has OE about 80-85% of earnings, whereas GM has an OE greater
than earnings (lots of depreciation and amortization!).
Here's some of the results:
Earnings growth
Discount Rate
7.0% 7.5% 8.0% 8.5% 9.0% 9.5% 10.0% 10.5% 11.0%
1.0% 15.73 14.45 13.36 12.41 11.58 10.85 10.20 9.62 9.10
1.5% 17.25 15.74 14.46 13.36 12.42 11.59 10.86 10.21 9.63
2.0% 19.07 17.25 15.74 14.46 13.37 12.42 11.59 10.86 10.21
2.5% 21.29 19.07 17.26 15.75 14.47 13.37 12.42 11.60 10.86
3.0% 24.07 21.29 19.07 17.26 15.75 14.47 13.38 12.43 11.60
3.5% 27.64 24.07 21.30 19.08 17.26 15.75 14.48 13.38 12.43
4.0% 32.40 27.64 24.07 21.30 19.08 17.27 15.76 14.48 13.38
4.5% 39.07 32.40 27.65 24.08 21.30 19.09 17.27 15.76 14.48
5.0% 49.07 39.07 32.41 27.65 24.08 21.31 19.09 17.28 15.77
5.5% 65.73 49.07 39.07 32.41 27.65 24.09 21.31 19.10 17.28
6.0% 99.07 65.74 49.07 39.08 32.42 27.66 24.09 21.32 19.10
As you can see, if a company grows at 5% forever and you use a 9%
discount rate (as Buffett might), you get a P/OE of 24.08. Now you
have to adjust for P/E. For a company whose P/OE is ~ 80% of earnings
this would indicate a P/E of about 19. Even if OE were usually only
50% of earnings, this would indicate a PE of 12, FROM A 5% GROWTH
RATE! So much for the old rule of thumb!
Now for higher growth companies, the above table doesn't work too well
as the growth rate exceeds the discount rate. On the flip side, high
rate growth can't continue forever. The following table shows P/OEs
for the listed growth rate over 10 years, followed by 5% growth after
that (similar to The Warren Buffett Way):
Earnings growth
Interest Rates
7.0% 7.5% 8.0% 8.5% 9.0% 9.5% 10.0% 10.5% 11.0%
10.0% 80.90 64.23 53.13 45.21 39.28 34.68 31.00 28.00 25.50
11.0% 88.08 69.84 57.69 49.03 42.55 37.52 33.50 30.22 27.50
12.0% 95.86 75.91 62.63 53.17 46.08 40.59 36.20 32.62 29.65
13.0% 104.26 82.47 67.97 57.63 49.90 43.90 39.11 35.21 31.97
14.0% 113.35 89.55 73.73 62.45 54.01 47.47 42.25 38.00 34.46
15.0% 123.16 97.21 79.94 67.64 58.45 51.31 45.63 40.99 37.15
16.0% 133.75 105.46 86.65 73.24 63.22 55.46 49.27 44.22 40.03
17.0% 145.18 114.36 93.87 79.28 68.37 59.92 53.18 47.69 43.14
18.0% 157.50 123.96 101.66 85.78 73.91 64.71 57.39 51.42 46.47
19.0% 170.77 134.29 110.04 92.77 79.87 69.88 61.91 55.43 50.06
20.0% 185.07 145.42 119.06 100.3 86.28 75.42 66.78 59.74 53.90
21.0% 200.46 157.39 128.76 108.3 93.17 81.38 72.00 64.36 58.03
22.0% 217.02 170.26 139.19 117.0 100.57 87.78 77.61 69.32 62.46
23.0% 234.82 184.10 150.40 126.4 108.51 94.65 83.62 74.65 67.21
24.0% 253.94 198.96 162.43 136.4 117.04 102.0 90.08 80.35 72.30
25.0% 274.49 214.92 175.35 147.2 126.19 109.9 96.99 86.47 77.76
26.0% 296.54 232.05 189.21 158.7 136.00 118.4 104.40 93.02 83.60
27.0% 320.20 250.41 204.07 171.1 146.51 127.4 112.34 100.0 89.85
28.0% 345.57 270.10 219.99 184.3 157.77 137.2 120.84 107.5 96.54
29.0% 372.75 291.20 237.05 198.5 169.82 147.6 129.94 115.5 103.69
30.0% 401.88 313.80 255.32 213.7 182.72 158.7 139.66 124.1 111.34
As you can see, a company that will grow at 15% for 10 years, then 5%
after that (like the ones in The Warren Buffett Way), and assuming
a 9% discount rate, can support a P/OE of 58.45!! Even assuming a
poor 2-to-1 ratio of earnings to OE, this would support a PE of 29,
almost twice the assumed 10 year growth rate!
So, basically, I put no weight at all in the old rule of thumb, or
PEG ratios. |
