So this is probably a meaningless exercise, but it occurs to me, given fact that many growth stocks purposely aren’t looking to maximize profit, that we could tweak the formula
Wow!, does that open up a can of worms, or what?
First, yes, people do this. Bert (Ticker Target) uses FCF to evaluate. But, you say, he just compares an FCF to revenue growth rate. For any given revenue growth rate he has established a standard FCF.FCF per share. But, the question is, “what is ‘standard’?” Sez who? In 5 year-old’s terms the answer is “'Cause Mommy says so.” Or in this case, the market says so. The wisdom of the market place for price discovery. But, just as USPT as $400 may or may not have been right, some multiple of FCF may or may not have been, or is, right.
Similarly, I was always puzzled by what seems to be firmly established wisdom that a company that is growing at 20% should have a p/e of 20. Don’t know how many times some Wizard of MF has stated that. Hint: There is no e=mc^2 for valuation. Pardon while I digress. At a more fundamental level, whether I invest in a stock, or a bond, or a lemonade stand or buy a house to rent, the value of that whatever is a comparison among them of the cash flow I expect to receive, versus the time and effort I spend and the degree of certainty that I’m going to actually receive it next week or next quarter or next year or…
It would seem to this simple soul that if I invest $500,000 in Synchrony Bank cd’s, layered from 1 to 5 years, I can eventually receive 3% per annum for the 5yr, but start with 1.4% for the first year. Well, o.k., I don’t have to do anything but, walk I suppose, to the bank (can’t afford to drive) and pick up the $58.33 on the first of each month. Would you like that in $1’s, says the teller. “No, in quarters, please, it seems like more.” So let’s forget CD’s.
Of course, the investing standard is the U.S. Treasury 10 year which is currently 2.817%, but safer than Synchrony Bank, one assumes. So let’s move on. No reason to look at corporate bonds, you get the idea. And the lemonade stand gets messy, both actually and figuratively. Let’s move on to my old friend DHIL, Diamond Hill This stock has gone slightly down and to the right over 5 years, pays 2.6% dividend. So higher risk than the U.S. treasury and lower yield Makes sense and the p/e is 8.0. That is semi-rational, but why would I take less for more risk? Well, now and then DHIL has traded over $200 versus today’s $175. Maybe I’m a trader of sorts.
Still with me? So lets take some companies with yields around the 2.81 treasury yield and their p/e and their earnings growth rate.
STOCK DIVIDEND EARNINGS P/E P/E
SYMBOL % YIELD % GROWTH TTM FYF
JNJ 2.54 44.67 23.85 17.34
KO 2.73 25.63 27.0 26.13
TSM 2.76 15.19 20.75 15.21
MGIC 2.80 16.34 26.11 15.09
AAP 2.87 33.67 21.29 15.23
FLO 3.11 34.93 27.64 21.06
IFNY 3.14 15.13 29.09 25.14
ED 3.35 17.46 21.41 21.01
* Earnings growth is MRFY vs. prior FY
So what? Well, the p/e could first be compared to the 100/2.81 (10-year treasury) to get the risk free p/e of 35.58. You would want to pay less than that and all do. Seem like all of these companies had good years on earnings growth. That must say something about, maybe, a bad prior year for businesses generally.
But, if there is an e=mc^2 for p/e, one would expect that it would be fn(Yd,Ge,R) [dividend yield, earnings growth, risk], and this relative to some standard, namely 35.58. So, pick a winner or two. JNJ, AAP, FLO. This model uses a standard, the 10-year treasury. At least there is that. But what Bert does is compare to a cohort of similar p/ev with a FCF tweak on a comparative basis. Who is to say that the comparisons are correct, and this is where Dreamer comes in with his “whatabout valuation?” Does the valuation of the cohort even make sense.
So when we look for a different kind of 1yrPEG and we were to use FCF, does FCF yield compare meaningfully [e=mc^2} to 35.58? Or do we care. Would it still be a question of whether the entire cohort does not make sense. What does FCF mean to me in lemonade stand speak. I mean, I can understand it at that level because I can see how FCF can eventually predict how much real cash I can expect and see what yield I am receiving versus my other options. If I were to invest in another rental property, the rents and expenses are relatively predictable and absent leverage I can just about be assured that I will, over a 1 or 2 year period have so much cash to spend. That’s why bonds used to be considered investing and stocks were speculation. Seems that stocks certainly can have quite a bit of speculation in them :).
So, a new model. 1) is there an e=mc^2 or 2) are we comparing cohorts, and 3) who says whether the cohorts are correctly valued and on what basis [see 1)]?
Whew. Thankfully, after 2000-2001 I built a base of rentals with now minimal, pocket change, leverage. DW loves it because she can see and touch the stuff and the value isn’t reported “in the newpaper” (remember those days?) on a daily basis. I digress.
Final answer to Dreamer’s question, is that these other metrics can be developed and are by such as Bert at Ticker Target, however they are comparative just like rev/ev and whether or not there is substance is, maybe just throwing rocks at the moon. 1yrPEG worked because it was linked to real earnings and it selected possibly interesting stocks that could be further evaluated wrt business model, future growth, risks, etc. It did not fail due to being a faulty approach, it failed because it was discovered by the masses and the p/e’s ballooned above reasonable levels and we ran out of candidates.