Calculating Fair Value With Growth
Our investing journey revolves around finding the fair value of a common stock.
If you can find stocks that are cheaper than its fair value, it is probably a buy.
If your stock holding rises way above your calculated fair value, it is most likely a sell.
This fair value is not constant, fluctuating due to several factors from interest rate movement and to commodity prices.
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.
Google did not exist a decade or so ago and it now rakes in billion of dollars of profit.
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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