As we enter a period of lower growth globally, investors have given higher valuations to companies that can achieve consistent growth. This seems logical, but are we in danger of overpaying?
That is a legitimate concern. But there is a way to avoid overpaying, in our view. Investors must apply a stringent analytical process to derive a fair value for the level of growth that a company can sustain over the coming years. After all, what good is owning a growth company in a low-growth world, if paying too lofty a multiple means that its stock price could be hit by the slightest bump in the road?
Three Steps to Estimating Value
Assessing value starts with growth forecasts. Step one is to build a five-year model of a company’s growth prospects that best reflects factors including the nature of its business, prevailing market conditions and the competitive environment. This gives us an earnings number in five years’ time.
The next step is to consider what multiple the market will likely attach to those earnings, which is almost always lower than the current value. We take the earnings number, multiply it by the company’s prospective value, and add dividend payments to determine a total value five years forward.
Then, we discount that number back to today to derive a current target price. The discount rate is the required rate of return we believe is necessary to justify an investment. This discount rate is composed of: a risk-free rate, usually the 10-year government bond yield; an equity risk premium, which is the excess return required by equity investors to justify the increased risk of owning a stock over a bond; and finally, a stock-specific risk to reflect the differing nature of companies.