Best of the Week
Most Popular
1. TESLA! Cathy Wood ARK Funds Bubble BURSTS! - 12th May 21
2.Stock Market Entering Early Summer Correction Trend Forecast - 10th May 21
3.GOLD GDX, HUI Stocks - Will Paradise Turn into a Dystopia? - 11th May 21
4.Crypto Bubble Bursts! Nicehash Suspends Coinbase Withdrawals, Bitcoin, Ethereum Bear Market Begins - 16th May 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.Cathy Wood Ark Invest Funds Bubble BURSTS! ARKK, ARKG, Tesla Entering Severe Bear Market - 13th May 21
7.Stock Market - Should You Be In Cash Right Now? - 17th May 21
8.Gold to Benefit from Mounting US Debt Pile - 14th May 21
9.Coronavius Covid-19 in Italy in August 2019! - 13th May 21
10.How to Invest in HIGH RISK Tech Stocks for 2021 and Beyond - Part 2 of 2 - 18th May 21
Last 7 days
Virgin Media Fibre Broadband Installation - What to Expect, Quality of Wiring, Service etc. - 21st Jun 21
Feel the Inflationary Heartbeat - 21st Jun 21
The Green Superfuel That Could Disrupt Global Energy Markers - 21st Jun 21
How Binance SCAMs Crypto Traders with UP DOWN Coins, Futures, Options and Leverage - Don't Get Bogdanoffed! - 20th Jun 21
Smart Money Accumulating Physical Silver Ahead Of New Basel III Regulations And Price Explosion To $44 - 20th Jun 21
Rambling Fed Triggers Gold/Silver Correction: Are Investors Being Duped? - 20th Jun 21
Gold: The Fed Wreaked Havoc on the Precious Metals - 20th Jun 21
Investing in the Tulip Crypto Mania 2021 - 19th Jun 21
Here’s Why Historic US Housing Market Boom Can Continue - 19th Jun 21
Cryptos: What the "Bizarre" World of Non-Fungible Tokens May Be Signaling - 19th Jun 21
Hyperinflationary Expectations: Reflections on Cryptocurrency and the Markets - 19th Jun 21
Gold Prices Investors beat Central Banks and Jewelry, as having the most Impact - 18th Jun 21
Has the Dust Settled After Fed Day? Not Just Yet - 18th Jun 21
Gold Asks: Will the Economic Boom Continue? - 18th Jun 21
STABLE COINS PONZI Crypto SCAM WARNING! Iron Titan CRASH to ZERO! Exit USDT While You Can! - 18th Jun 21
FOMC Surprise Takeaways - 18th Jun 21
Youtube Upload Stuck at 0% QUICK FIXES Solutions Tutorial - 18th Jun 21
AI Stock Buying Levels, Ratings, Valuations Video - 18th Jun 21
AI Stock Buying Levels, Ratings, Valuations and Trend Analysis into Market Correction - 17th Jun 21
Stocks, Gold, Silver Markets Inflation Tipping Point - 17th Jun 21
Letting Yourself Relax with Activities That You Might Not Have Considered - 17th Jun 21
RAMPANT MONEY PRINTING INFLATION BIG PICTURE! - 16th Jun 21
The Federal Reserve and Inflation - 16th Jun 21
Inflation Soars 5%! Will Gold Skyrocket? - 16th Jun 21
Stock Market Sentiment Speaks: Inflation Is For Fools - 16th Jun 21
Four News Events That Could Drive Gold Bullion Demand - 16th Jun 21
5 ways that crypto is changing the face of online casinos - 16th Jun 21
Transitory Inflation Debate - 15th Jun 21
USDX: The Cleanest Shirt Among the Dirty Laundry - 15th Jun 21
Inflation and Stock Market SPX Record Highs. PPI, FOMC Meeting in Focus - 15th Jun 21
Stock Market SPX 4310 Right Around the Corner! - 15th Jun 21
AI Stocks Strength vs Weakness - Why Selling Google or Facebook is a Big Mistake! - 14th Jun 21
The Bitcoin Crime Wave Hits - 14th Jun 21
Gold Time for Consolidation and Lower Volatility - 14th Jun 21
More Banks & Investors Are NOT Believing Fed Propaganda - 14th Jun 21
Market Inflation Bets – Squaring or Not - 14th Jun 21
Is Gold Really an Inflation Hedge? - 14th Jun 21
The FED Holds the Market. How Long Will It Last? - 14th Jun 21
Coinbase vs Binance for Bitcoin, Ethereum Crypto Trading & Investing During Bear Market 2021 - 11th Jun 21
Gold Price $4000 – Insurance, A Hedge, An Investment - 11th Jun 21
What Drives Gold Prices? (Don't Say "the Fed!") - 11th Jun 21
Why You Need to Buy and Hold Gold Now - 11th Jun 21
Big Pharma Is Back! Biotech Skyrockets On Biogen’s New Alzheimer Drug Approval - 11th Jun 21
Top 5 AI Tech Stocks Trend Analysis, Buying Levels, Ratings and Valuations - 10th Jun 21
Gold’s Inflation Utility - 10th Jun 21
The Fuel Of The Future That’s 9 Times More Efficient Than Lithium - 10th Jun 21
Challenges facing the law industry in 2021 - 10th Jun 21
SELL USDT Tether Before Ponzi Scheme Implodes Triggering 90% Bitcoin CRASH in Cryptos Lehman Bros - 9th Jun 21
Stock Market Sentiment Speaks: Prepare For Volatility - 9th Jun 21
Gold Mining Stocks: Which Door Will Investors Choose? - 9th Jun 21
Fed ‘Taper’ Talk Is Back: Will a Tantrum Follow? - 9th Jun 21
Scientists Discover New Renewable Fuel 3 Times More Powerful Than Gasoline - 9th Jun 21
How do I Choose an Online Trading Broker? - 9th Jun 21
Fed’s Tools are Broken - 8th Jun 21
Stock Market Approaching an Intermediate peak! - 8th Jun 21
Could This Household Chemical Become The Superfuel Of The Future? - 8th Jun 21
The Return of Inflation. Can Gold Withstand the Dark Side? - 7th Jun 21
Why "Trouble is Brewing" for the U.S. Housing Market - 7th Jun 21
Stock Market Volatility Crash Course (VIX vs VVIX) – Learn How to Profit From Volatility - 7th Jun 21
Computer Vision Is Like Investing in the Internet in the ‘90s - 7th Jun 21
MAPLINS - Sheffield Down Memory Lane, Before the Shop Closed its Doors for the Last Time - 7th Jun 21
Wire Brush vs Block Paving Driveway Weeds - How Much Work, Nest Way to Kill Weeds? - 7th Jun 21
When Markets Get Scared and Reverse - 7th Jun 21
Is A New Superfuel About To Take Over Energy Markets? - 7th Jun 21

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

How to Know What Rate of Return to Expect from your Stocks: Part 1

InvestorEducation / Learning to Invest Jun 30, 2012 - 08:40 AM GMT

By: Charles_Carnevale

InvestorEducation

Best Financial Markets Analysis ArticleWe believe there are two critical attributes that the prudent investor should consider before investing in a company (stock). Furthermore, these same two attributes can be used to calculate a reasonable expectation of the future return the stock is capable of generating on their behalf. These two attributes are valuation and the rate of change of earnings growth. Valuation indicates whether or not the company's current earnings power compensates you for the risk you take, while the company's future rate of change of earnings growth will be the driver of future returns.


We believe these are very important concepts for prudent investors to understand for several reasons. First of all, you can make an investment at fair value into a low or slow growth company, and still not generate a high rate of return. On the other hand, the risk associated with achieving it is normally low. This is simply because achieving a low rate of earnings growth is easier to do. Conversely, you could overpay, perhaps even significantly so, for a very powerful or fast grower and still make a high rate of return, because of the power of compounding.

However, by overpaying you are taking on more risk than you should for two reasons. First of all, the probability of a company achieving a very high rate of growth is very low, and second, longer term it's virtually a given that price will return to fair value. Therefore, the investor will not be able to harvest the full measure of the company's growth achievement. More simply stated, the probability of a future PE contraction is very high. The effect is a lower rate of return than deserved, while illogically taking a higher level of risk than necessary to obtain the lower return.

To summarize, if a company grows fast enough, then future earnings growth can overcome a high beginning valuation. However, the risk taken to achieve it is amplified by the high valuation. Conversely, if you come across an opportunity to buy a stock at a very low valuation, even a low growth company, your return potential is greatly enhanced while simultaneously your risk is greatly lessened.

On the other hand, overpaying for a slow grower (for example, a typical utility stock) destroys your return potential while simultaneously turning what might normally be a low-risk investment into a high risk investment. In the same vein, if you can find a slow grower that is significantly undervalued, you could generate a high return and arguably achieve it at very low risk.

Valuation Demystified

As stated in our introduction, valuation is one of what we believe to be the two most important attributes that investors should consider before investing in a stock. Yet, fair valuation alone does not automatically indicate a high future return or even an adequate one. In truth, valuation is a relative concept that becomes relevant to future return only when looked at in conjunction with future growth. Throughout this report, we will illustrate that valuation unto itself is most relevant in the context of current time. In other words, valuation itself applies predominantly to current fundamentals. Consequently, we see valuation more as a measurement of soundness than we do as a rate of return expectation.

As a result, both a moderately fast-growing stock and a very slow-growing stock can command the same valuation in current time. However, given fair valuation for both, the faster grower offers a higher future return. This concept can apply to all classes of stocks to include non-dividend paying stocks as well as dividend paying stocks (Later in this article I will more clearly reveal this principle with specific examples). The point I am stressing is that valuation is more related to soundness than it is to future returns. Even more simply stated, valuation is about prudent behavior and risk mitigation.

To illustrate this more clearly, we are going to utilize the most common valuation measurement, the PE ratio. But first and foremost, we want to emphatically state that the PE ratio is more than a mere statistical inference. Instead, our objective is to illuminate the idea that the PE ratio is a relevant measurement of valuation that represents the appropriate compensation for the amount of risk currently being assumed. The key to understanding this is to recognize the PE ratio as a measurement of the earnings yield the investment is offering.

To put this into perspective, consider that the long-term average PE ratio of the S&P 500 has been, depending on the time frame being measured, somewhere between 14 to 16 times earnings (S&P 500 average PE 14 - 16). Jeremy Siegel, professor of finance at the Wharton School of the University of Pennsylvania has written that stocks have returned an average of 6.5% to 7% per year, after inflation, over the last 200 years. For simplicity sake, we are going to hang our hats on the historical average S&P 500 PE ratio of 15.

Now, up to this point, the average PE ratio of 15 for the S&P 500 is simply a statistic. However, a statistic is information, but information alone is not wisdom. To our way of thinking, answering the important question as to why a PE ratio of 15 is common over such a long period of time, is more critical than simply knowing the number itself. In order to accomplish this, let's analyze what PE ratios of 14 - 16 translate into in terms of rate of return calculations. What we discover is that a PE ratio of 15 represents a reasonable and attractive rate of return of approximately 6% to 7%, that has historically been achieved (the long-term stock market average), and therefore logically considered acceptable and achievable.

To add clarity to this point, let's actually calculate the rate of return (earnings yield) that a PE of 14, 15 or 16 represents. To determine the earnings yield, simply reverse the PE ratio (Price divided by Earnings) and calculate the EP ratio (Earnings divided by Price). Therefore, we learn that a PE ratio of 14 equals an earnings yield of 7.1%, a PE ratio of 15 equals an earnings yield of 6.66% and finally a PE ratio of 16 equals an earnings yield of 6.25%. Therefore, we learn through wisdom, that it is no coincidence that these calculations coincide almost perfectly with Prof. Jeremy Siegel's historical statistic of average stock market returns of 6.5% to 7%.

In other words, an average stock market PE of approximately 15 (14-16) is rational and makes economic sense because it represents an appropriate yield on investment, which is why it is so commonly applied to the valuation of most stocks. However, for this to be relevant enough to be considered wisdom, it needs to also practically apply in real world circumstances. To practically apply, we must be able to see and measure evidence that clearly shows that the average fair value PE ratio of 15 actually does manifest in reality.

Testing the Fair Value 15 PE Ratio Hypothesis

In order to test the fair value PE ratio of 15, we will utilize the earnings and price correlated Fundamentals Analyzer Software Tool - F.A.S.T. Graphs™. This powerful "tool to think with" utilizes widely accepted formulas for valuing a business. Utilizing these formulas, appropriate valuations in the form of PE ratios are calculated.

Interestingly, these formulas tend to calculate the fair value PE ratio to be approximately 15 for companies whose earnings growth has historically averaged 3% to 15% per annum. Companies whose growth is below 3% will calculate out at PE ratios slightly less than 15. For very fast growing companies (above 15%), a different formula that calculates higher PE ratios applies, and will be presented later. This supports the 200-year 6.5% to 7% yield that Prof. Jeremy Siegel reported (Remember, a PE of 15 equals an earnings yield of 6.66%).

Once the fair value PE ratio is calculated, monthly closing stock prices are overlaid onto the graphs in order to discover if there is a strong price and earnings correlation. If the formulas are valid, then we should see a very close association between earnings and stock price relative to a PE ratio of 15 over time.

The following four earnings and price correlated F.A.S.T. Graphs™ illustrate how the market has historically valued companies that possess varying growth rates that range within the 3% to 15% growth category at a PE of 15. The reader should note that each of these samples show that the calculated PE (the orange line) and the normal PE historically applied by the market (dark blue line) are virtually the same, or at least close.

SCANA Corp (SCG): A Low Growth Regulated Utility

Our first example plots SCANA Corp. whose earnings growth rate has averaged only 3.3% per annum. Here, we would like to remind the reader that our position is that fair valuation is a function of the earnings yield that "current earnings" represent. Consequently, purchasing a company at fair valuation implies that the investor is making a sound financial decision. However, as previously stated, this does not necessarily guarantee a high future rate of return. As we will illustrate in Part 2, that will be determined by the company's future earnings growth rate.

The orange line on the following graph represents our fair value PE ratio of 15 applied to SCANA Corp.'s historical earnings since calendar year 1998. To be clear, every point on the orange line equals a PE ratio of 15. The Graham Dodd Formula was used to calculate the fair value PE ratio of 15 and is expressed to the right of the graph in orange letters - GDF X 15. According to our thesis, if this truly is a fair value PE ratio, when the stock price overlay is applied, then price should track the orange line very closely over time.

SCANA CORP (SCG)

Our next graph overlays monthly closing stock prices with our orange earnings justified valuation line. Moreover, two additional important valuation metrics are also added. The light blue shaded area expresses dividends paid out of earnings (the green shaded area). The dark blue line represents our algorithm calculating the normal PE ratio that the market has historically applied to this business over this time period.

Clearly, we see that the black price line tracks the orange earnings justified valuation line (PE = 15) almost perfectly. The normal PE ratio (14.4) is also almost a perfect match indicating that the market has historically appraised this company at approximately 15 times earnings. Furthermore, during the short-term time periods when price temporarily deviates from earnings, we see that it soon returns. Therefore, we discover in this example that fair valuation exists any time the stock is trading at a PE ratio of 15 or below. (Note: Once again, the rate of return that this produces is a different matter that will be elaborated on in part 2).

SCANA CORP (SCG)

OGE Energy Corp. (OGE): Another Utility with Slightly Higher Growth

Our second example, OGE Energy Corp, differs from our first only by virtue of the fact that its earnings growth rate since 1998 has averaged over 5% per annum. Nevertheless, we once again discover that the PE ratio of 15 represents a strong proxy for this company's valuation. During the short time intervals when price deviates from fair value PE of 15, it doesn't take long for price to move back into alignment with earnings.

Furthermore, during this time frame there have been almost no incidences of overvaluation with either of our first two examples. However, in both cases we see that when the PE ratio falls substantially below our PE 15 standard, the opportunity for higher rewards at significantly lower risk clearly manifest.

OGE Energy Corp (OGE)

Wolverine World Wide (WWW): A Faster Growing Global Marketer of Footwear

Our third example, Wolverine World Wide, moves farther up the growth chain with earnings averaging 9.4% per annum. Nevertheless, we once again see the strong relationship and close correlation between stock price and earnings over the long run. Perhaps due to the faster earnings growth rate, we do see several periods where the company's price earnings ratio has deviated significantly above the 15 standard, indicating overvaluation. Nevertheless, just as we saw with our first two examples, stock price inevitably and soon moves back into alignment with earnings.

Wolverine World Wide (WWW)

Inter Parfums, Inc. (IPAR): Develops, Manufactures and Distributes Prestige Perfumes

Our final example, Inter Parfums, Inc., is an above-average growing small-cap that validates our PE 15 standard, but with a twist. Small capitalization companies tend to carry greater risk than larger capitalization companies. As a result, it is not uncommon to see, as we do with Inter Parfums, Inc., an earnings and price correlated graphic with wilder price swings.

On the other hand, we believe the following graphic clearly validates the thesis of fair valuation. The PE 15 principle continues to apply over the long run. More directly stated, price does track earnings, albeit with violently volatile price swings in between. But most importantly, in spite of all the price gyrations, stock price continues to quickly and inevitably revert to the fair value PE ratio mean of 15.

Inter Parfums Inc (IPAR)

Summary and Conclusions

In this Part 1 of this two-part series, the majority of our focus has been on the principle of fair valuation, or as we like to call it - True Worth™. Our contention is that by understanding and accepting the idea that fair valuation is primarily a metric of soundness, it simultaneously lays the foundation for determining future returns from a common stock investment. However, as we will expand upon in Part 2, valuation is a relative measurement. Therefore, when viewed in isolation, it does not provide an accurate future return calculator.

In order to calculate future returns within a reasonable degree of accuracy, we must consider valuation as it relates to earnings growth. In this Part 1, we have provided evidence that fair valuation calculates out to be very similar for companies generating earnings growth of 3% to 15% per year. Our thesis is that fair valuation is, first and foremost, a function of a stock's current earnings yield. This is why companies with different earnings growth rates will command similar, if not identical, current valuations. However, as we will develop in Part 2, thanks to the power of compounding, when growth becomes very fast (above 15%) a higher valuation becomes justified.

But perhaps most importantly, in Part 2 we intend to demonstrate how investors in common stocks can utilize the principle of valuation in conjunction with the company's expected future earnings growth rate to determine reasonable future rate of return expectations. We believe these are critical components for investors to master. Because, when valuation is understood and looked at in conjunction with future earnings growth, risk assessments also become more clear and accurate. Consequently, not only can investors have a better idea of what rate of return they can expect, but they can also ascertain how much risk they are taking to generate it. As a result, smarter, sounder and more profitable buy, sell and hold decisions can be made.

Disclosure: Long SCG at the time of writing.

By Chuck Carnevale

http://www.fastgraphs.com/

Charles (Chuck) C. Carnevale is the creator of F.A.S.T. Graphs™. Chuck is also co-founder of an investment management firm.  He has been working in the securities industry since 1970: he has been a partner with a private NYSE member firm, the President of a NASD firm, Vice President and Regional Marketing Director for a major AMEX listed company, and an Associate Vice President and Investment Consulting Services Coordinator for a major NYSE member firm.

Prior to forming his own investment firm, he was a partner in a 30-year-old established registered investment advisory in Tampa, Florida. Chuck holds a Bachelor of Science in Economics and Finance from the University of Tampa. Chuck is a sought-after public speaker who is very passionate about spreading the critical message of prudence in money management. Chuck is a Veteran of the Vietnam War and was awarded both the Bronze Star and the Vietnam Honor Medal.

© 2012 Copyright Charles (Chuck) C. Carnevale - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in