Our investing journey revolves around finding the fair value of a common stock. If you can find a stock that is cheaper than its fair value, it is probably a buy. Previously, I stated that the fair value (selling price) of a stock is when its P/E hits 13.4. This gives investors a yield of 7.45%, which is 3% above the current yield of a 10 year treasury bond. We use 10 year treasury bond as our proxy for 'free risk' interest rate. Now, obviously, you have seen a lot more stocks valued at a P/E of more than 13.4, some as high as 30. Are they overvalued? Not necessarily since my P/E calculation assume a 0% growth.
As you may know, earnings does not stay constant all the time. So, how do we value company with a growing earning? Now, I don't normally assume growth when calculating fair value, but I am going to take a stab at it today.
For now, let's make things really simple. We'll assume that EPS for the current year is $ 1.00 . Furthermore, earning growth will be 10% for the next 5 years and then stay constant afterwards. I think this is a realistic assumption. Predicting earning growth beyond the 5 years is like predicting who will be the next president 5 years in advance.
Now, our next step is to determine that constant EPS after 5 years of growth. With EPS of $ 1.00, 5 years from now, EPS will come in at $ 1.61. So, if we bring this back to the present, how much is this $ 1.61 worth? Please note that $ 1.61 now is more valuable than $ 1.61 five years from now. Using a 4.5% discount rate, that $ 1.61 of future earning is worth $ 1.29 per share today.
Therefore, in essence, the company will be earning $ 1.29 constantly with 0% growth. Using a P/E of 13.4, the company has a fair value of $ 17.32. At this price, the company is valued at 17.3 trailing P/E ratio. You can do similar exercise to other companies with higher growth rate. You'll find out that some of them are valued at a P/E of 30 or more with the growth assumption built into it.
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