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What P/E multiple should you pay for growth stocks?

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March 06, 2014 – Comments (11)

In the 1977 annual letter to Berkshire Hathaway shareholders, Warren Buffet had the following to say about buying stocks:

We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety.  We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price.

He goes onto to say that in later annual letters that there are dozens and dozens of companies that meet criteria 1-3, but meeting criteria 4 “often prevents action.”

In order to determine a price that investors should pay for a company, let’s delve into the Price to Earnings (P/E) multiple.

If a stock is trading at a P/E of 10, then the earnings yield on the market equity is about 10%. An example of this would be a stock is trading for $100/share and earns $10/share.  Assuming that management deploys those earnings back into value-generating activities (dividends, buybacks, high-returning capital projects, etc.), you are earning a theoretical 10% per year on your investment.  Part of the return might come through capital appreciation and part of the return might come via dividends.

If a stock is trading at a 15 multiple, you are paying more for those earnings.  The earnings yield on this investment would be 6.7%.  For a 20 P/E, the yield would be 5%; for a 30 P/E the yield would be 3.3% and for a 40 P/E the yield would be 2.5%.

So why would anyone want a 2.5, 3.3, or even a 5% theoretical earnings yield from a stock, when you can get a cash yield form a corporate bond?  The earnings yield on a stock might not even happen – it’s theoretical!

Well the issue with a bond is that while it’s considered very safe, it isn’t going to grow any.  If you buy a bond that yields 3%, years down the road you’re still only going to get 3%.  Alternatively, if you buy a stock that is yielding 3% in earnings, and it grows 15% every year, by the end of the 10th year, your earnings yield on the initial purchase will be 12%!  and if you happen to find one of those few companies that can grow earnings at 15% for 20 years, your earnings yield would be an astounding 50% per year by the 20th year!

These types of companies aren’t rare – their right in front of your face!  Panera, Family Dollar, Bed Bath and Beyond – these are all companies that have growth earnings at double-digit clips for years  and years.

But this doesn’t mean you should just pay any price for a stock that has the potential for growth.  Expected growth can become derailed very quickly, and that expected 15% growth you were looking for could turn out to be more like 5% growth.  Taking a conservative approach to paying for growth should be employed.

Peter Lynch’s philosophy on paying for growth stocks fell along these lines – you should simply try to buy stocks that the same P/E multiple that you expect the company to grow.  So if you expect a company to grow earnings at 20% per year, you should pay a 20 P/E for the stock  (this is where the PEG ratio comes from – a 20 PE divided by 20% growth gives you a PEG of 1.0).

However, this type of investment is truly an anomaly.  A company trading at a 20 P/E provides an earnings yield of 5%.  If this company were to actually grow at 20% per year, the 5% earnings yield you got at the initial purchase would balloon to 30% just by year 10.  Lynch had a very strict criteria for paying for growth stocks – when you get your hands on these types, you are in for some serious market-beating returns.

Ben Graham on the other hand, offered up some advice that is a bit more theoretical about paying for growth.  In his famous book, The Intelligent Investor, Graham suggested paying a bit more for companies as long as you are certain those growth rates are going to be achieved.  For a stock expected to grow 3% per year, you could pay a 16 P/E and still see decent returns.  For a stock expected to grow 6%, you could pay a 20 P/E.  For a stock expected to grow 10%, you could pay a 30 P/E.  But Graham is talking about long-term (10 year) growth rates, not the expected growth rate over a 2-3 year span.

And this makes sense!  If you buy a company at a P/E 30 and are getting a 3.3% yield (for a PEG of 3.3), after 10 years of compounding at 10%, your earnings yield would be nearly 9%.  That’s not bad, considering that the earnings growth likely won’t stop right there.  From that point on, earnings would probably continue to grow, even if it’s at a rate slightly less than 10% per year.

So what advice should you follow?  Finding companies with a PEG of 1.0 or paying a bit more like Graham suggests?

If you can actually find a company that is trading at the same P/E multiple as its long term expected growth rate, you should definitely pounce on it.  It would likely return 15, 20, or even 30% growth per year.  But – you need to be sure that the company has a realistic chance of meeting those growth expectations.  I’d steer clear of Graham’s theoretical advice, simply due to the fact that investors need some margin of error when making purchasing decisions for growth stocks.

Here are a few companies that have been growing EPS in the double digits for a long, long, time, and are trading at reasonable P/E ratios.

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11 Comments – Post Your Own

#1) On March 06, 2014 at 1:28 PM, Mega (99.97) wrote:

Discounted cash flow (DCF) analysis is the theoretically correct approach. It is a more powerful and flexible tool than rules of thumb like PEG or Graham number.

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#2) On March 06, 2014 at 2:19 PM, ElCid16 (97.08) wrote:

Mega - you highlight the advantages of the DCF compared to a rule of thumb approach: theoretical correctness, flexibility, and power.  

What about the disadvantages?  There are lots of those, too.

I did my fair share of DCFs while I was getting my MBA, and I attempted to continue using them as a tool for valuing equities once I finished.  I felt that the added benefit of getting the "precise" answer (read: modeled answer) wasn't that useful.  An investor as savvy as yourself doesn't need a model to tell you that a stock is at fair value at $13.74, when you can eyeball it at $11 and say: yeah this is a good deal.

Furthermore, I found DCFs to be much more useful for valuing companies at the enterprise level, and not so much at the per share level.  You see lots of i-bankers and PE guys using DCFs because they're pitching and selling entire companies.  These guys aren't pitching shares of Home Depot.

Buffett often says that he can tell within about 5 minutes if a company is potentially worth a given purchase price.  Do you think he's cracking open his Lenovo ThinkPad to put together a DCF in Excel? 

Buffett and Munger on Financial Models 

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#3) On March 06, 2014 at 2:26 PM, ElCid16 (97.08) wrote:

Most Frequent Errors in DCF Models

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#4) On March 06, 2014 at 2:58 PM, Mega (99.97) wrote:

"Buffett often says that he can tell within about 5 minutes if a company is potentially worth a given purchase price.  Do you think he's cracking open his Lenovo ThinkPad to put together a DCF in Excel?"

No, of course not. I think he does a very rough DCF in his head. With something more complex like the Heinz acquisition, he probably wrote down a financial model (or worked with his staff to develop one).

His writing is light on specific ratios and calculations, but you can read between the lines. Alice Schroeder mentioned that he has filled filing cabinets with his thoughts on potential investments, including a fair amount of numbers.

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#5) On March 07, 2014 at 6:00 AM, jiltin (32.07) wrote:

I used this calculator (I am novice to dcf)

http://www.gurufocus.com/fair_value_dcf.php

It gives better picture for goog,csco etc, but the values are far from reality for TSLA,FB,NFLX and even AAPL.

Any clue or idea which is the better calculator?

Any reference is appreciated.

Thanks 

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#6) On March 07, 2014 at 9:37 AM, JohnCLeven (76.22) wrote:

Have you ever tried using reverse DCF's as an added tool?

Instead of using growth assumptions to arrive at an intrinsic value, adjust the growth assumption until you arrive at the current stock price. The growth assumption that got you you the the current market price can be thought of as the "baked in" growth assumed by the market.

Most of the time, the baked in assumption is rational or at least semi-rational.

Once in a blue moon, you find completely outlandish baked in assumptions. If the insane assumption is too low of a growth assumption, then you might have a good idea on your hands.

I've only ever bought 8 stocks in my 3 years of investing. One of them was AAP, and it was a reverse DCF that convicned me to buy.

Two years ago AAP was selling for about $67. A reverse DCF showed that, at that price, a mere 2-3% annual growth rate was "baked in." If you know anything about the history and performance of AAP, then you would know that a 2-3% growth assumption was insane.

The business exceeded those insanely low expectations in the recent year, and the stock has done very well since.

I'm not suggesting reverse DCF as a primary tool, but more of a quick and convienent secondary tool, to lead to further analysis.

And it really only makes sense for very consistent companies where you have at least a reasonably narrow range of probably future outcomes.

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#7) On March 07, 2014 at 9:59 AM, JohnCLeven (76.22) wrote:

Probable*

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#8) On March 07, 2014 at 1:34 PM, ElCid16 (97.08) wrote:

John - in short, yes!  All the time. 

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#9) On March 07, 2014 at 2:56 PM, Mega (99.97) wrote:

John, have you ever looked at Deere? It may be up your alley. ROA and ROI are a little low but it is because of their financing arm. ROE is great and still improving.

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#10) On March 07, 2014 at 5:14 PM, JohnCLeven (76.22) wrote:

Thanks Mega,

I've looked at Deere a couple times, and have tossed them into the too hard pile each time.

As you mentioned ROA, and ROI are low, and that does concern me. And i'm no expert on how financing arms affect value. I've avoided GE for the same reason. I'm still a rookie at this investing think, and have tried to avoid things that I don't understand adequately.

No doubt that Deere is a great household names. I regularly see John Deere signage go for hundreds of dollars on ebay...not many companies have a brand that strong. Their industry position is enviable as well.

The other parts I don't understand is that they are cyclical, and I have little to know experience with cyclical companies. Or those that are heavily effected by gloabal macro conditions, which I think DE is as well.

My ignorance may well result in passing up on a great oppurtunity with Deere. I really should look at Deere's 10-K's again, and see if the scales fall from my eyes or not.

Thanks very much for the rec!

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#11) On March 07, 2014 at 7:24 PM, jiltin (32.07) wrote:

John, Thank you

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