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

March 06, 2014
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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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