Our investing journey revolves around finding the fair value of
a common stock. You can invest in companies that grow rapidly
and lose money. On the other hand, you can also invest in
companies in a declining industry, yet you can still make money.
Investing profitably does not merely depend on what you invest
in, but rather how much you pay for a given company.
Therefore, let's look at company with negative earning growth.
How do we value them? For a 0% growth company, P/E ratio for the
fair value is 13.4, which is equal to 7.45% return year in and
year out. For negative growth company, P/E ratio should be lower
of course, since it is giving less and less as the year goes by.
Let's try valuing negative growth with the following assumption.
EPS growth is negative ten percent for the next five years and
then stay constant. EPS for the current year is $ 1.00. So,
after five years, EPS will come in at $ 0.59. Now, this is the
constant $ 0.59 that we will get five years from now. The value
of that cash flow today assuming 4.5% discounting rate is $
0.47. Applying P/E of 13.4, this company is fairly valued at $
6.34. Currently, earning per share comes in at $ 1.00 per share.
If you look at the stock trading at $ 6.00, you may think that
it is cheap since it is trading at a P/E of 6. But, if you
expect it to have negative growth of negative ten percent for
the next five years, this P/E of 6 doesn't sound cheap after all.
If you expect negative growth, even a seemingly low P/E ratio
does not translate into profitable investment. The industry I
can think of right now is the auto industry. The US auto maker
has been struggling for years to compete with its Japanese
counterparts. Investors has priced in negative growth for quite
sometime now. If you look at say GM or Ford, they have been
trading at a seemingly low P/E ratio for several years. Until
this year, both of them has been able to post profits. This
year, they are all expected to post a loss. The moral of the
story here is to watch out for company with low P/E ratio.
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