Our investing journey revolves around finding the fair value of
a common stock. If you can find stocks that are cheaper than its
fair value, it is probably a buy. If your stock holding rises
way above your calculated fair value, it is most likely a sell.
This fair value is not constant, fluctuating due to several
factors from interest rate movement and to commodity prices.
Previously, I stated that the fair value (selling price) of a
stock is when its P/E hits 13.4. This gives investors a yield of
7.45%, which is 3% above the current yield of a 10 year treasury
bond. We use 10 year treasury bond as our proxy for 'free risk'
interest rate. Now, obviously, you have seen a lot more stocks
valued at a P/E of more than 13.4, some as high as 30. Are they
overvalued? Not necessarily since my P/E calculation assume a 0%
growth.
As you may know, earnings does not stay constant all the time.
Google did not exist a decade ago and it now rakes in billion of
dollars of profit. So, how do we value company with a growing
earning? Now, I don't normally assume growth when calculating
fair value, but I am going to take a stab at it today.
For now, let's make things really simple. We'll assume that EPS
for the current year is $ 1.00 . Furthermore, earning growth
will be 10% for the next 5 years and then stay constant
afterwards. I think this is a realistic assumption. Predicting
earning growth beyond the 5 years is like predicting who will be
the next president 5 years in advance.
Now, our next step is to determine that constant EPS after 5
years of growth. With EPS of $ 1.00, 5 years from now, EPS will
come in at $ 1.61. So, if we bring this back to the present, how
much is this $ 1.61 worth? Please note that $ 1.61 now is more
valuable than $ 1.61 five years from now. Using a 4.5% discount
rate, that $ 1.61 of future earning is worth $ 1.29 per share
today.
Therefore, in essence, the company will be earning $ 1.29
constantly with 0% growth. Using a P/E of 13.4, the company has
a fair value of $ 17.32. At this price, the company is valued at
17.3 trailing P/E ratio. You can do similar exercise to other
companies with higher growth rate. You'll find out that some of
them are valued at a P/E of 30 or more with the growth
assumption built into it.
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