"Justification for high P/E" Haim: I was stewing over these “Internet valuations”. the other day. I gave it a try, how does the market arrive at a P/E of 136 for CISCO ?
What growth must be assumed to arrive at this P/E ? Any P/E can be justified if there is enough growth, for a long enough time.
I can't attach the spreadsheet to a post, both with formulas and values in the cells. Be glad to try as E-mail (I am still using an 1991 Mac Excel 3.0)
The results: The spreadsheet assumes 25%/yr growth rate in the profit of $ 1.00 (in Year 1) for three 5-year periods and 20 % in the fourth 5-year period. 20 years.
Then all these future profits are discounted at the current 30-year Treasury bond rate of about 5.8 % (now 5.9 %:)
Out comes a P/E number of 131 - close enough. 131 is the sum of all discounted future profits.
So, these are the assumptions that apparently go into that kind of P/E.
Hmmm scratching my head. Let's vary, see what 5 more years will do.
Aha! This begins to make sense. When the discount rate is so low and the growth rate so high, five more years add quite a bit. P/E is 250 or so.
When the 5-year growth rates are reduced as follows
1st 2nd 3rd 4th 5th 5-year period (Total = 25 years)
25% 20% 15% 15% 15%
then the "Justifiable P/E" is still 128 !!! The assumption the market makes is apparently that the Internet will drive profits for a long time ! Well, there may be plausibility to it. The invention of the steam engine, and later of the electric generator and motor, caused long booms. The question is, will CISCO or company X bloom that long ?
When using 6 % instead of 5.8 % for UST , the P/E drops to 124, from 128 for the case above. Not that bad.
As I said, this was run for CSCO but you get the picture.
Is there an error in logic ? Let me know what you think
Walter in HK |
