The challenge for investors is trying to come up with a reasonable value for a company that is growing fast but also is considered expensive when compared to other companies or the overall market.
There is a solution.
One idea to help investors understand some of the risks in valuation, is looking at current P/E (price/earnings) vs. future P/E ratios and then this relationship to future growth rates.
Examples tend to help illustrate the thought process around this idea.
Let’s use an example to help us understand the concept.
A company that has been growing its EPS (earnings per share) on average by 25% for the last several years and the market has been valuing the company with a P/E ratio of 45. In this example, we are comfortable with the future EPS growth rate of 25%, as we expect this growth to continue for some time. However, we are concerned that the P/E multiple might come down from its current 45 and be repriced with a more in-line market multiple of 25.
If the market reprices this company, how long will it take the company’s EPS to justify a P/E of 25?
Let’s calculate.
Current Valuation:
The initial P/E is 45, so the P (Price) = 45 * EPS (Earnings Per Share)
Target Condition (the risk):
The company P/E will now be 25 without changing the price, so we’ll need the EPS to grow until the stock price divided by the EPS equals 25.
(P / Future EPS) = 25
Growth in EPS:
Future EPS = E * (1 + .250) ^ n
Setting up and solving the equation:
P/E * EPS = Future P/E * Future EPS
- 45 * E = 25 * (E * (1 + 0.25) ^ n))
- 45 / 25 = (1.25) ^ n
- 1.8 = (1.25) ^ n
- ln (1.8) = n * ln (1.25)
- n = [ln (1.8) / ln (1.25)]
- n = [(.5877) / (.2231)]
- n = 2.63 or 2 years and 8 months
So this tells us that a company that is expecting to grow at 25% would take approximately 2 years and 8 months to support a P/E ratio of 25. If an investor is comfortable with this assumption of growth and possible P/E compression, then it could make sense to buy a company that is trading at what would initially look like a very lofty valuation in relationship to the market averages.
We can also run various “what-if” scenarios, like reducing the growth rate from 25% to 20%. How much does this impact the number of years to support a P/E ratio of 25? In this case, it would take 3.22 years.
Additionally, if you purchased a security, this process can be used to help determine if you “over paid,” and if so, how long it will take for the company’s earnings to catch up with its valuation.
Like personal growth, strong company growth can help overcome a lot, even if your initial starting point was less than ideal.
-Paul R. Rossi, CFA