Introduction

To me, fair value, as it relates to common stock investments, is manifest when the current earnings yield provided by the company’s profits compensates me for the risk I am taking by providing both a realistic and acceptable return on my invested capital. Most importantly, as will be explained later, current earnings yield and its relevance to fair value is independent and/or separate from future growth.

The Importance of Current Earnings Yield

When referencing my definition of fair value, it’s important to focus on the concept “current earnings yield.” There a couple reasons why I feel this is both rational and important. First, the current earnings of a given business are typically accurate within reason (reported earnings). Therefore, the calculation of the return that the current earnings are offering me can be more accurately calculated than if you were using future estimated earnings. To clarify a little farther, after years of extensive research and experience, I have determined (or at least satisfied myself) that a P/E ratio of 15 represents fair valuation for most (but not all) companies based on realistically achievable growth rates.

The 15 P/E Ratio Reflects Fair Value Under Real-World Circumstances

After examining thousands of companies over several decades, through the lens of the FAST Graphs (Fundamentals Analyzer Software Tool), I have observed that a 15 P/E ratio represents historical fair value for earnings growth up to 15% per annum. Although there are exceptions to every rule, it is no accident that a 15 P/E ratio is so ubiquitous. There are logical factors and real-world evidence that support a 15 P/E as a rational fair valuation for most, but not all companies.

First, I believe that it is not a coincidence that the more than 200-year average P/E ratio of the S&P 500 has been between 14 to 16. Second, this is a real-world occurrence because I believe it also represents, and is consistent with, the long-term average return of 6% to 8% that common stocks have traditionally delivered to investors.

This fact is further supported by the reality that a 15 P/E ratio represents an earnings yield (E/P) of 6.67%, or approximately 6% to 7%. My point being, that this is a rational and realistically achievable rate of return commonly found in the real world of stock investing. But I believe the most important point regarding this 15 P/E concept rests on the notion of soundness, not rate of return as I presented in part 1 found here. When the current earnings yield is between 6% and 7%, the investment is currently prudent whether (or not) the business grows, and almost regardless of the company’s rate of growth (up to a point – 15%).