## Price-Earnings versus Growth

A comment at lunch today about high price-earnings multiples got me started on one of my favorite topics: investment returns.

Most of us use the basic price-earnings ratio (PE or P/E) as a rough measure of how highly priced a stock is. The higher the P/E, the higher the risk.

But P/E only focuses on current earnings and ignores future growth which can make a huge difference to the return on your investment.

The PEG ratio, popularized by Peter Lynch in One Up On Wall Street, attempts to address this deficiency by dividing the price-earnings ratio by expected long-term growth rate of earnings.

• more than 1.0 is poor;
• less than 1.0 is good;
• less than 0.5 is excellent.

Comparing P/E to long-term growth is a step in the right direction but the PEG ratio has two notable deficiencies:

• It ignores dividends; and
• It assumes that the relationship between P/E and growth is linear.

### Dividends

It is fairly obvious that two stocks trading on the same P/E, and with the same expected long-term growth rate, do not present the same value if one pays regular dividends and the other does not. PEG can be adjusted to compensate for this deficiency, by adding the dividend yield to the expected growth rate. If we assume Computershare (ASX:CPU), for example, has a long-term growth rate of 10%, this should be adjusted to 12% to include the expected 2% dividend yield.

### P/E versus Growth

The relationship is not linear. Take a look at the graph below which compares P/E ratios on the vertical axis to Growth (including dividend yield) on the horizontal axis.

The gray line plots stock prices at a PEG ratio of 1. A P/E of 10 intersects with growth at 10%, a P/E of 20 with growth at 20%, etc.

The green line plots an internal rate of return at 12.5% p.a. on investment. Here is a brief explanation of my calculation:

I project earnings of \$1 at varying growth rates for a period of 20 years. Then I discount this at 12.5% p.a. to arrive at a present value which equates to the P/E ratio (PV/\$1 earnings in Year 1). I assume an exit value of zero for two reasons: (a) to simplify the model; and (b) to compensate for declining growth rates over time. I can give you ten different alternatives but this seems the most effective treatment (and I am trying to avoid this reading like a PhD thesis).

The relationship between P/E and expected growth rate is clearly exponential. If we require an annual return on investment (ROI) of 12.5% :

• A growth rate of 15% would justify a P/E of 22; while
• A growth rate of 30% would justify a P/E of 97.

What is clear is that price may be dictated more by high expected earnings growth than by current earnings.

How do we estimate long-term earnings growth? With difficulty.

But this is the most important factor in determining a stock’s value so we need to make our best effort. Factors to consider include:

• Past revenue growth (earnings growth without corresponding revenue growth is difficult to sustain);
• Cash flow to fund future growth
• Market position
• Market growth or market saturation
• Market share
• Ability to withstand competition (rising profit margins are often a good pointer)

### Conclusion

The next time you look at a PE ratio, remember that earnings growth may be more important than current earnings.

## Is the S&P 500 overvalued?

The daily press appears convinced the S&P 500 is overvalued and due for a crash. Yet the macro-economic and volatility filters that we use at Porter Capital and Research & Investment — to identify market risk so that we can move to cash when risks are elevated — show no signs of stress. So I have been delving into some of the aggregate index data, kindly provided by Standard and Poors, to see whether some of their arguments hold water.

The Price-Earnings ratio for the S&P 500 itself is not excessive when compared to the last decade.

The bears argue, however, that earnings are unsustainable. One reason advanced for this is that earnings growth has outstripped sales, with corporations focusing on the bottom line rather than business growth.

Faced with weak domestic demand, large US corporates have actively sought to manage their expenses so as to meet and exceed the market’s expectations. Combined with the unwinding of provisions taken in the GFC, cost management has allowed US corporates to achieve a 124% increase in 12-month trailing earnings off the back of a 25% increase in 12-month trailing sales since October 2009.
~ Elliott Clarke, Westpac

That may be so, but any profit increase would look massive if compared to earnings in 2009. When we plot earnings against sales (per share), it tells a different story. Earnings as a percentage of sales is in the same band (7% – 9%) as 2003 to 2006. A rise above 9% would suggest that earnings may not be sustainable, but not if they continue in their current range.

The second reason advanced is that business investment is falling. Westpac put up a chart that shows US equipment investment growth is close to zero. But we also need to consider that accelerated tax write-offs led to a surge in investment in 2009/2010. The accelerated write-offs expired, but the level of investment merely stopped growing and has not fallen as I had expected.

Private (non-residential) fixed investment as a whole is rising as a percentage of GDP, not falling.

Lastly, when we compare the S&P 500 to underlying net asset value per share, it shows how frothy the market was before the Dotcom crash, with the index trading at 5 times book value. That kind of premium is clearly unsustainable without double-digit GDP growth, which was never going to happen. But the current ratio of below 2.50 is modest compared to the past decade and quite sustainable.

I am not saying that everything is rosy — it never is — but if sales and earnings continue to grow apace, and with private fixed investment rising, the current price-earnings ratio does not look excessive.

## Is the S&P 500 overvalued?

The daily press appears convinced the S&P 500 is overvalued and due for a crash. Yet the macro-economic and volatility filters that we use at Porter Capital and Research & Investment — to identify market risk so that we can move to cash when risks are elevated — show no signs of stress. So I have been delving into some of the aggregate index data, kindly provided by Standard and Poors, to see whether some of their arguments hold water.

The Price-Earnings ratio for the S&P 500 itself is not excessive when compared to the last decade.

The bears argue, however, that earnings are unsustainable. One reason advanced for this is that earnings growth has outstripped sales, with corporations focusing on the bottom line rather than business growth.

Faced with weak domestic demand, large US corporates have actively sought to manage their expenses so as to meet and exceed the market’s expectations. Combined with the unwinding of provisions taken in the GFC, cost management has allowed US corporates to achieve a 124% increase in 12-month trailing earnings off the back of a 25% increase in 12-month trailing sales since October 2009.
~ Elliott Clarke, Westpac

That may be so, but any profit increase would look massive if compared to earnings in 2009. When we plot earnings against sales (per share), it tells a different story. Earnings as a percentage of sales is in the same band (7% – 9%) as 2003 to 2006. A rise above 9% would suggest that earnings may not be sustainable, but not if they continue in their current range.

The second reason advanced is that business investment is falling. Westpac put up a chart that shows US equipment investment growth is close to zero. But we also need to consider that accelerated tax write-offs led to a surge in investment in 2009/2010. The accelerated write-offs expired, but the level of investment merely stopped growing and has not fallen as I had expected.

Private (non-residential) fixed investment as a whole is rising as a percentage of GDP, not falling.

Lastly, when we compare the S&P 500 to underlying net asset value per share, it shows how frothy the market was before the Dotcom crash, with the index trading at 5 times book value. That kind of premium is clearly unsustainable without double-digit GDP growth, which was never going to happen. But the current ratio of below 2.50 is modest compared to the past decade and quite sustainable.

I am not saying that everything is rosy — it never is — but if sales and earnings continue to grow apace, and with private fixed investment rising, the current price-earnings ratio does not look excessive.