Price Follows Earnings

What makes the P/E the most useful way to express the price of a stock is the fact that it acknowledges that it’s earnings that actually drive a stock’s price, disregarding all of the short-term ups and downs. Therefore, in a perfect world, as a company’s earnings grow, so should the price. And, that being the case, the relationship between the two should be fairly constant. At any time, one should therefore be able to express a reasonable price using approximately the same P/E. What should that P/E be?

It depends, of course, upon the industry the company is in and the niche that the company occupies within that industry. Such intangibles as franchise value — the premium that investors are willing to pay for market leaders with long success records and healthy corporate cultures — will help to determine that valuation. And, of course, the final arbiter is the collective market.

However, a sound and successful growth company will establish a reasonable “signature P/E or multiple” that is the expression of all of those intangibles. And the company, over the course of its life, can be expected to see only a modest decline in that multiple.

Indeed, a bit of a paradox lies in the fact that the more successful the company is, the lower that signature P/E will go. This is because the company’s ability to continue to grow its revenues at the same percent each year lessens with the magnitude of the revenues that such growth generates. It’s a lot easier for a million dollar company to increase its revenues by 20 percent than for a billion dollar company to do so. However, for all practical purposes, you should be able to expect a company’s stock to sell at its signature multiple, or close to it, for at least a five-year time horizon — long enough to forecast for your purposes.

Assessing a “Fair Price”

Probably the closest you can come to assessing that signature multiple or “fair price” is to look at the average P/E over some period of time. For normal companies a five-year period will probably suffice because that will take into account both the top and bottom of a normal business cycle. But, for companies like the “hot” tech stocks and some of the others that went along for the ride — or those that were forsaken — during the last half of the 1990s, one would have to look further into the past because there was no “normal” business cycle during that period. During the dot.com bubble of the 1990s, the Greater Fool Theory kept multiples irrationally pumped up beyond reason. For such companies, it would be best to look 10 years into the past. That way you might balance the high P/Es with the low ones and come up with a more reasonable average.

And, for the glamorous companies without that much history, it would be best to wait until they have established such a track record — or at least have taken one or two “hits” to season their managements.
We said above that in a perfect world the P/E would remain reasonably constant over the life of a company while its revenues and resultant earnings continue to grow. However, the P/E is also a measure of the investor confidence which ebbs and flows with things other than the basic driver, earnings. The world is by no means perfect.

Continue to Part 3 >>>