In part 2 of this series I focused on how to value slow and moderately growing businesses. In this article, Part 3, I will shift my focus on how to value faster growing companies (growth stocks). My definition of a fast grower (growth stock) is one that has consistently compounded earnings at 15% per annum or better over extended periods of time (five years or longer). Furthermore, the more consistent the growth has been, the better it fits my definition of a pure growth stock.
In Part 1, I also offered the idea that a P/E ratio of 15 was appropriate for most companies. However, with this article I will further refine that concept by suggesting that a P/E ratio of 15 applies when growth rates fell in the range of 0% to 15%. In other words, in addition to the fact that the P/E ratio of 15 has been the average for indices like the S&P 500, there is also a logical and mathematical reality behind its validity. However, although a P/E ratio of 15 was an appropriate valuation to pay for growth of up to 15%, I also pointed out that it did not necessarily indicate the rate of return investors should expect to receive. The ultimate rate of return achieved will be related to the valuation paid and the subsequent growth that the company achieves.
Also, the 15 P/E ratio should not be looked at as an absolute, instead it should be viewed as a baseline barometer for fair value. In other words, the 15 P/E is a good starting point guideline to ensure that you are not overpaying and taking too much risk. Consequently, anytime you come across a moderately growing company (5%-15%), whether a blue-chip or even a moderate to high dividend payer that is trading at a P/E ratio above 15, then caution is called for.
Exceptions to The Rule – Premium Valuations
However, there are certain companies that will always command a premium valuation even when their earnings growth is within the 5 to 15% range. Echo Labs (ECL), Sysco (SYY) and Automatic Data Processing (ADP) are three examples as depicted in the long-term historical FAST Graphs below:
Echo Labs: Historically Valued at a 25-ish P/E Ratio
From the historical earnings and price correlated graph on Echo Labs we see that the market has chronically valued this stock at a P/E ratio in the 25-ish range (The actual P/E of the dark blue line is 26.87). Additionally, note that this stock has never traded at a theoretical fair value P/E ratio of 15 over this entire timeframe. There are exceptions to every rule. The key is to clearly evaluate what you see and accept it as historical reality.
Automatic Data Processing (ADP): Historically Valued at a 20-ish P/E
Once again, we see an example of a company that the market likes to apply a premium earnings valuation to (P/E ratio 20-ish). However, with this example we do see a few occasions where the price did trade at the theoretical fair value P/E ratio of 15. In other words, the price touched the orange P/E ratio 15 line. These rare periods of time when the stock could be purchased at a P/E ratio of 15 or slightly below would be considered optimum for this example.