In Part 1 of this series found here, we voiced the notion that there are two primary attributes, valuation and the rate of change of earnings growth, which prudent investors can use to forecast the potential future returns on their stocks.

However, Part 1 was primarily focused on ascertaining the principles which laid the foundation for sound current valuation.

[ad#Google Adsense 336×280-IA]In this Part 2, we will focus on how to utilize current valuation in conjunction with earnings growth rates in order to come up with a reasonable expectation of the future total returns a stock can be expected to provide.

The point is that neither can be looked at in isolation.

In other words, the price you pay to buy the growth that the company ultimately delivers, will determine not only how much money you make (the percentage return on investment), but how much risk you took to make it.

Moreover, in Part 1, we concerned ourselves with defining historical norms relating to valuation, and then provided historical evidence to back them up. But even more importantly, we strove to illustrate that there is a practical rationale that underpinned our calculations of soundness. This practical rationale is the calculation of the earnings yield (earnings divided by price) that a given valuation (PE ratio) represents.

The general idea here is that a company’s profitability ought to represent an acceptable rate of return on your investment. After all, when all is said and done, when you “invest” in a common stock you are buying the business. If that business isn’t making enough money to give you a decent return on your investment, then common sense would indicate that you’re overpaying for it.

Another way of looking at this is to understand and acknowledge that a business gets its value from the amount of cash flow it is capable of generating for its stakeholders (owners or shareholders). At this point, it’s important that the reader recognizes the previous statement as a metaphor.

In other words, we are using the word “cash flow” to represent the amount of money the business is making you if you are an owner. Furthermore, in the context of this article we consider the word “cash flow” as interchangeable with profits or earnings. Our objective is to focus on the essence of valuation so that the principle can be understood, and not get caught up in semantics or accounting convention.

Analogy of a Hypothetical Private Company

With this in mind, we offer the following analogy. Let’s assume that you own a private business that pays you $100,000 a year of income (salary, dividends, bonuses, etc.). We will also assume that your business provides a guaranteed $100,000 per year in income, no risk and no growth. Furthermore, we also assume that you live in the perfect society with no taxes. Remember, our objective is to focus on the essence of valuation.

Now let’s further assume that you are tired of working and want to sell the business. The seminal question is at what price will you be willing to sell? The logical answer would be at some reasonable multiple of one year’s worth of your earnings. Put another way, if a business generates a predictable annual income stream, it has a value greater than that income stream, even at zero growth. Because logically, if you sold the business for only $100,000, or one times earnings, you would be out of money in one year.

Therefore, in order to sell, you would need a multiple of one year’s earnings that you can use to provide yourself a comparable future income stream in your new retirement. If we use the multiple of 15 (a PE of 15), our standard of value presented in Part 1, we would get a selling price of $1,500,000.

Now, if we could invest the $1,500,000 into a passive investment (Bond, CD, Public Dividend Paying Stock, etc.) at our established historically reasonable return of 6.66% (PE=15), we discover that our income would be $99,900 per year (approximately $100,000 per year). Note: This provides some insight into the underlying reason for a normal PE of 15, because the historical average annual return on stocks has been approximately somewhere between 6-9%. Therefore, the return a 15 PE represents is both believable and historically achievable.

Consequently, both the seller and buyer in our metaphorical analogy would be provided a sound and reasonable return. The seller can take the proceeds and generate a future return adequate enough to provide a comfortable retirement, and the buyer simultaneously is earning a reasonable return on their investment in the operating business. The point is that the income stream is driving the value, and it’s the income stream that gives a business its worth, whether it’s a publicly traded stock on an exchange, or private.

Risk, Return and the Valuation Relationships

Thus far, we have established a baseline of valuation using a hypothetical guaranteed and static income stream-no risk and no growth. However, in the real world, a business’ income stream is neither static nor guaranteed. Furthermore, the more dynamic the income stream, the more risk associated with achieving it.

Some cases in point would include the notions that faster growth is harder to achieve than slower growth, and consistent growth would be generally considered more predictable than cyclical growth. Therefore, we now introduce two new concepts; risk and compounding. Risk will tend to lower or reduce the valuation a prudent investor is willing to pay for a given investment, and a higher rate of earnings growth tends to increase future value (compounding).

Therefore, risk and earnings growth rates will represent counteracting forces affecting starting or current valuation (PE’s). This partially explains why a 3% grower (less risky to achieve) might command the same current valuation PE of, for example, an 11% or 12% grower (riskier and harder to achieve). But this is a critical point; the faster grower will generate a higher future return than the slower grower, ceteris paribas.

Pictures Are Worth a Thousand Words

From this point forward, we are going to rely on FAST Graphs’ earnings and price correlated graphs and performance charts to vividly express the valuation and return relationships. Therefore, the following pictures will more succinctly articulate the principles this series of articles has been developing. But for the reader to receive any insights from the graphics, a few words of explanation on them is in order.

  • The orange earnings justified valuation lines on each graph are calculated by applying widely accepted formulas commonly utilized to value a business. There is no manipulation or adjustments made. The PE ratios represented are calculated and applied for the time period graphed.
  • The slope of the orange earnings justified line is equal to the calculated earnings growth rate. Importantly, although the PE may be the same or similar for two respective companies, the growth rate (slope of the line) can differ dramatically (this is a key to return calculations).
  • The calculated PE ratio on each graph is the same for every point on the graph. The applicable PE is listed to the right of each graph in orange letters with the formula designation, GDF for Graham Dodd Formula, PEG for PEG ratio (PE=Growth Rate) and GDF-PEG representing an extrapolation between the other two.
  • The dark blue line is a calculated blended normal (historical) PE. In other words, the PE that the market has actually applied to the company historically.
  • The light blue shaded area represents dividends paid out of the green shaded area earnings. Dividends, if any, represent an important component of the total return calculation.
  • To interpret the graphs correctly, the reader must look to the right of the graph for essential mathematical factors that apply to each respective company.
  • For illustration purposes, we strove to provide examples where valuations were aligned at both the beginning and the end of each time period; or at least approximately so. This allows the reader to more clearly see the relationship between earnings growth and return over time.

From this point forward additional insights into historical valuation and return calculations and future estimates of both will be interjected by example with each subsequent graph. Generally, we will start with lower growth and move to faster growth with each following example.

Examples of the PE = 15 Standard for Earnings Growth Rates from 0% to 15%

Vectren Corp. (VVC): A Low Growth Utility

Our first example looks at Vectren Corp’s historical earnings, a utility with a 15-year historical earnings growth rate that is below our 3% threshold established in Part 1. Note that fair valuation is calculated using Graham Dodd’s Formula (GDF) deriving a fair value PE of 13.8 (slightly below, but close to our PE 15 standard). However, a normal PE of 16 has been historically applied by Mr. Market. Therefore, valuation falls between a PE of 13.8 to 16, or well within a range of normalcy.

With our second graph we introduce and overlay monthly closing stock price. Here we discover that for the most part, price tracks earnings within the corridor of the orange and the blue line. This provides historical evidence of the practical reality of a normal PE of 15, plus or minus a minor deviation from time to time for a slow, or almost no growth, company. However, this example also provides historical evidence that the earnings growth rate drives the capital appreciation component of total return as we will discover when we review the performance table next.

When analyzing the performance associated with Vectren Corp, we learn that capital appreciation (closing annualized rate of return) of 1.2% closely matches earnings growth of 1.7%. Thereby, we establish that the rate of change of earnings growth relates closely to capital appreciation.

So now we have one important piece of the return puzzle, earnings growth. Also, since beginning valuation was approximately at a PE of 16 (blue normal PE line) and so was ending valuation, little valuation adjustment to capital appreciation applies.

This example also provides important insight into the relevance of dividends to total return. Although we will expand on dividends in more detail with future examples, we learn here that dividends provide a return in addition to capital appreciation from earnings growth (see circles on the table).

Note that this is a main reason that FAST Graphs expresses dividends on top of earnings even though they are paid out of earnings. Dividends (paid out and not reinvested in the table) provide additional return above appreciation.

Nextera Energy (NEE): A Moderately Growing Utility

With our second example we move up the food chain of growth by reviewing Nextera Energy a moderately faster growing utility stock. Even though Nextera Energy’s growth rate is more than 3 times faster, averaging 6.4% per annum, we discover that valuation within our PE = 15 range. To be clear, what this tells us is that investing in Nextera at a PE ratio of approximately 15 represents a sound and historically normal valuation.

However, we also once again see evidence that a reasonable current valuation represents soundness, but as we will soon see, the rate of change of earnings growth will determine our actual future returns.

As you review the graphic, note that whenever the price line deviates from the orange earnings justified valuation line, it inevitably comes back into alignment with fair value.

Therefore, the slope of the line at 6.4% becomes the driver of the capital appreciation component of return when valuation is aligned at the beginning and the ending time period measured.

When reviewing the performance table associated with the Nextera Energy graphic above, we once again see a very close correlation and relationship between earnings growth and capital appreciation at approximately 6% per annum.

Moreover, we discover that the dividend growth rate also coincides very closely with earnings growth over time. And, we once again see that dividends (not reinvested) represent additional return.

We believe the real takeaway here is that sound valuation coupled with a company’s earnings growth rate will allow the investor to earn a return that equates with the company’s earnings growth.

However, if the company pays dividends, they will represent a return kicker above and beyond earnings growth. On the other hand, the rate of dividend growth and earnings growth will generally correlate, ceteris paribus (all things remaining equal).

VF Corp. (VFC): Leading Apparel Company

With our third example, VF Corp., we again move further up the growth chain where earnings growth has averaged 8.6% per annum. Again, we discover that the PE = 15 standard continues to apply. However, for companies growing between 5%-15% the extrapolated formula mentioned above automatically calculates fair value. From the graphic, it is clear that a 15 PE represents a reasonable proxy for fair valuation.

At this point, we find it appropriate to interject the idea that fair valuation is not an absolute. Instead, it should be thought of as a reasonable range of soundness that can be utilized to make fair value investing decisions.

In this example, we also discover that the normal PE ratio that Mr. Market has typically applied to VF Corp. is 13.1, slightly below our PE = 15 standard. The only logical reason that we can surmise for this adjustment, is the possibility of the market’s perception of risk.

Nevertheless, it should be clear from the graphic that a PE ratio ranging between 13-15 has historically applied to this company. In other words, armed with this information, the prudent investor might only consider investing in this company when the PE ratio is at 13 or lower. On the other hand, as we will soon see, a PE of 15 would not be a disastrous idea.

Once again we see a high correlation between earnings growth and capital appreciation. However, notice the effect that an expanding payout ratio has had on total dividends, and therefore, total return.

Hormel Foods Corp.

With this next example, we move closer to the upper end of our range of earnings growth where we have discovered that a PE ratio of 15 normally applies as a reasonable valuation measurement. However, we also see that the market has generally rewarded this faster and rather consistent earnings growth rate with a premium PE ratio of 17.2.

Consequently, and as with this example, faster growth does warrant a higher valuation, as many may have suspected, the 15 PE still offers a proxy for valuation.

On the other hand, you could pay up to 17 times earnings or slightly higher, and still earn a decent return on a company with this growth rate. Remember, valuation serves as a guide, not an absolute.

Also, in this case, the consistent rate of above-average growth provided by a food company providing basic human needs may be considered less risky than an apparel stock.

When evaluating the performance on Hormel Foods Company (HRL), we continue to see a strong correlation between earnings and return.

However, a slight overvaluation at the beginning (see red circle) reduced capital appreciation from an expected 11.8% that mirrored earnings growth to only 9.5%. This casts a bright light on the importance and power of earnings growth as it relates to long-term return.

In other words, an above-average growth rate can overcome a moderately bad valuation decision in the long run. And dividends can mitigate a moderately poor investing decision even more.

Growth of 15% Per Annum or Better An Inflection Point

As we discussed in Part 1, historical evidence and logic imply that the normal PE ratio of approximately 15 is a reasonable proxy for fair valuation on many companies.

However, we’ve also attempted to illustrate that fair valuation alone does not indicate a strong return. Instead, fair or sound valuation will allow you to earn a return that equates (approximates) to the company’s earnings growth rate over time, plus dividends, if any.

Our observations of thousands of companies utilizing the earnings and price correlated FAST Graphs (Fundamentals Analyzer Software Tool), have led us to conclude and discover that once earnings growth exceeds 15% per annum, fair valuation reaches an inflection point.

We believe that this is predominantly a function of the power of compounding. Once a company’s growth rate exceeds 15% per annum, the stream of income that it produces (past or future) expands geometrically.

Therefore, our research indicates that fair valuation rises above the PE=15 standard and begins approximating the company’s earnings growth rate up to growth between 35% and 40% per annum. Above 40% earnings growth rates, valuation ratios begin to blur.

We believe this is attributed to the enormous risk associated with achieving such high rates of growth. Consequently, the market as a general rule will discount growth rates above 40% by applying a lower PE ratio.

Ross Stores Inc.

Our first example of high growth is Ross Stores Inc. (ROST) that has averaged earnings growth of 17.6%, indicating a fair value PEG ratio PE of 17.6. However, and interestingly, notice that the normal PE ratio sits close to our standard PE ratio of 15. In this case, a PE of 15 might represent a risk adjusted valuation below the higher earnings growth of 17.6%. Nevertheless, buying this stock at a PE of 17 still delivers a strong long-term rate of return.

Current overvaluation, indicated by the current blended PE ratio of 20.1 explains capital appreciation above earnings growth of 17.6%. Furthermore, due to the power of compounding, although dividends contribute to total return, capital appreciation provides the majority of shareholder returns in this example.

Church & Dwight Inc.

Church & Dwight Inc. (CHD) provides almost the identical growth rates of our Ross Stores’ example above. However, notice how the market in this case has applied a premium historical PE ratio of 19.7 that is greater than the earnings growth rate of 17.7%. We believe this indicates a lower risk premium applied to this consumer staples company over a riskier retailer such as Ross Stores.

Once again, we see that an above-average rate of return correlates very closely to this company’s above-average earnings growth rate. Since valuation was sound at the beginning, and since Church & Dwight is moderately overvalued currently, annualized total return exceeds earnings growth rate.

Oracle Corp. Fast Growing Software Company

Oracle (ORCL) offers several lessons on how to calculate the returns from your common stock investments. First of all, we see a strong correlation between earnings and stock price for most of the 15-year time frame. However, we also see the extreme and unwarranted overvaluation that occurred during the irrationally exuberant technology bubble of the late 1990s.

Although Oracle is currently undervalued based on its historical earnings growth, we still see that long-term returns relate to the company’s earnings growth rate, discounted by undervaluation.

We thought it would be useful towards understanding the theme of this series of articles to look at what impact overvaluation had on Oracle’s long-term returns since 2001. From the following graph we can see that valuation was very high at the time.

Consequently, extreme overvaluation almost totally wiped out long-term shareholder returns even though earnings growth was strong. However, notice that earnings growth has fallen from 19.6% over the 15-year period to 14.5% over the 12-year period. Earnings growth is a dynamic concept and fair valuation is therefore fluid as well.

Liquidity Services Inc. (LQDT)

Our final example of fast growth looks at Liquidity Services Inc. Although somewhat cyclical, we see that stock prices have tracked earnings growth very closely. Moreover, we see that the market has typically applied a fair value PE ratio that equates very closely with the company’s earnings growth rate, thereby providing additional evidence of the validity of the PE equals growth rate valuation concept applies to fast growth above 15%.

Cyclical Stocks but the Valuation Rules Continue to Apply

The following example looking at Cooper Cos. Inc. (COO), and reveals a very cyclical company that provides insight into the PE equals 15 hypotheses that this series of articles has presented. Clearly, price follows earnings even when earnings are dropping, and interestingly, the market tends to apply our standard PE equals 15 even when this happens.

Summary Conclusions

Our goals with this series of articles, was to establish a framework, and hopefully insights, into how an investor can know what rate of return to expect from their stocks. Simply stated, it’s a function of valuation coupled with earnings growth. Unfortunately, time and space only allowed us to scratch the surface of these important investor concepts. Therefore, a Part 3 addendum to this series is in order that will primarily deal with forecasting future returns based on these principles. However, we are hopeful that the essence of return was adequately expressed thus far.

Furthermore, in order to receive the maximum insight and benefit from this series, it’s imperative that the reader spend the majority of their time analyzing and evaluating the graphics presented. These FAST Graphs not only express the relationships to return that were offered, they simultaneously provide historical evidence of the veracity of the hypotheses as well.

Finally, and most importantly, the reader should keep in mind that what was discussed here represents ranges as well as nuances of valuation and return. These are multifaceted concepts that are also adjusted by risk as we attempted to iterate. Therefore, these concepts should serve more as guides. In other words, these concepts provide practical guidelines, but they lack perfect precision, mostly due to the uncertainties that are always associated with investing in common stocks.

– Chuck Carnevale of FAST Graphs

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Source: FAST Graphs

Disclosure: Long NEE, VFC, ORCL & ROST at the time of writing.