The stock return is a function of the combination of sales/earnings growth and valuation. Consequently, I build my portfolio at a time based on past sales growth, future earning power and the current valuation. It does not matter to me if the market is high or low, the only thing that matters to me is the valuation of the specific business and its future growth potentials. I only invest when the VALUATION on the specific business I am studying makes economic sense.
Just like a Treasury bond trades at a multiple of interest rates, a common stock trade at a multiple of its income stream which is generally represented as earnings and expressed as P/E ratio. The reason, I mentioned a safe but no growth fixed income vehicle is to establish the minimum foundation level. Historically, the average P/E that has been applied to the average company [the S&P 500] for the past 200 years has been approximately within a range of 15-16. This calculates to an earning yield of approximately 6% to 7%. I don’t believe it is a coincidence that this also represents the long-term average return that stocks have produced. I additionally pointed out that this valuation calculation also relates to normal long-term fixed income yield of 6% to 8%.
Without presenting a long and detailed explanation:
The fair value P/E ratio of 15 represents a sound proxy of fair valuation for companies with earning growth ranging from 0% to 15%. Extensive research over many years has led me to conclude that a P/E ratio equal to a company earnings growth rate [P/E = EPS growth] is more appropriate for companies that grow at greater than 15% rates.
“Never overpay for a stock. More money is lost than any other way by projecting above-average growth and paying an extra multiple for it.” – Charles Neubauser.
There are always good companies that are overpriced. A disciplined investor avoids them. Investors must remember that their first job is to minimize losses and preserve capital. And after they have dealt with that, they can approach the second job, seeking return on the capital.
Keep in mind that returns are a function of the combination of earnings growth and valuation. If a company has a 20 P/E ratio but a 30% earnings stream, it is actually an underpriced stock. You want to buy it. Its price/earnings-to-growth ratio of PEG is less than one [0.67 x]. You are getting paid to take on that growth! In essence, PEG ratio above one mean you are overpaying for growth and PEG ratio south of one mean the exact opposite.
If you look at the performance of stocks that have substantial gains over time, you tend to notice a few things. One is that there a strong correlation between earnings growth and stock appreciation [obvious]. And second factor is the change in the valuation multiple [P/E expansion or contraction]. So how can we use the process? Start with a company that has demonstrated a good historical growth pattern and has a future growth prospects and a reasonable valuation and ‘sit quietly in a room”.
Focus on business performance and valuation, not on day to day news. Pascal – All mankind’s trouble are caused by one thing, which is their inability to sit quietly in a room. Pogo – We have met the enemy – and he is us.
Return decreases as motion increases. Never confuse investing with trading. Don’t try to time the market on P/E valuation. It is not like Physics, where if you run the same experiment in a lab, every time you get the same result. Three of the most important variables to consider are to identify the growth companies, valuation of the stocks when you buy them and the length of the time you stay invested.