06-5-18. Written by James M. Esler
The sentiment lately is both confident and greedy. Looking at 20 year charts, the markets have never shown companies to be so expensive. The phrase, “There will be someone to pay me more for this” is beginning to take hold in a very strong way. The long term investor cannot afford to speculate in such ways.
The largest determinant of the expensiveness of corporations is the price to earnings multiple. By using a strategy similar to the ‘Gordon Growth’ Model, the investor can determine when the outlay will be recovered. For the below exercise, we analyze XYZ corporation. Let’s assume that the market price of XYZ is $100, it’s earnings at the end of this year are expected to be $5, and the growth in earnings will be 15% per year for the next 15 years.
XYZ has very strong growth expected here, which is the biggest problem and a reason that the price to earnings ratio often becomes very rich. The 15% growth rate can easily be derailed by any number of Porter’s Five Forces (and the business cycle) over that 15 years. For a company growing mightily, sustaining such growth is very difficult, especially in established industries.
XYZ is trading at 20 times expected earnings. We will assume that the required return on equity is 3%. This number is hypothetical, but also is low due to a very low interest rate environment at this time. Using a 15% growth, the company would ‘earn back’ the investor’s outlay of $100 after almost 12 years. Thus, if the company can sustain a 15% growth rate over 12 years, and if XYZ is expected to grow earnings over the required return in the future, the investor made a proper investment. The price after 12 years of a stock that does not pay a dividend should be the $100 outlay with compounded retained earnings added. Thus, if we assume that the market in 12 years will price XYZ at 20 times earnings, the investor will finally be able to sell at $2000. This is a compound annual growth rate of 28%.
However, because 12 years have passed, XYZ will likely have a much lower sustainable growth rate (ie 5%). Thus, the market should price it at a lower earnings multiple (ie 5 times). At a 5 times multiple, XYZ will trade for $500 and the investor got an overall return per year of 14%.
If XYZ will not be able to out-earn the required rate, it will likely sell for around it’s earnings, and the investor will not receive any gain over the 12 years.
The two largest risks are:
- Does the investor have the ability to wait a considerable amount of time on the investment, especially if the timing for a sale is not ideal?
- What are the risks involved that could derail the earnings growth in those 12 years?
Clearly, if the market initially offered a price to earnings multiple of 10 rather than 20, there is much more certainty for the investor. Thus, a value investor always waits for the proper entry point. Such an investment is not intended to be a short term hold – the investor has bought a company with sustainable earnings growth at an attractive price. Research is critical to determine if the company has sustainable earnings potential.
Ideally, the investor would recover his outlay in a time frame that he has planned out prior to making any type of investment. Thus, many investors would be wise to seek the help of an investment advisor to determine the time horizon for all of the investor’s goals. However, the investment advisor is also critical to determine which companies have defensive and sustainable earnings growth.
If the investor cannot invest for the 12 years or if the earnings growth could erode significantly, the investor should find a safer return investment such as debt securities or preferred equities. The defensiveness of the earnings growth is often a component of the ‘margin of safety’.
So you see that investing in stocks is very similar to investing in bonds – where stocks retain earnings just as a bond (or dividend stock) pays a cash yield. Bonds, of course, should pay back 100% of the outlay in the end. As detailed above, stocks have no high probability of return an investor’s outlay. This is why security selection is very important.