In various places, and even around Fooldom, I’ve come across a rule of thumb for P/E of growth companies being the growth rate of revenues or earnings. Easy, but doesn’t make sense to me. Maybe for a certain range of growth the rule is good, like a broken clock being right twice a day.
Say a retailer is profitable but earnings are low because cash flow from operations are being invested in expansion. It is growing 20% per year without taking on debt. It is trading at a P/E of 40 and analysts and bloggers say it is overpriced.
On the other hand, a company is growing 3% a year and making a profit as it has for the last 20 years: From a value standpoint, one could look at Graham’s approach of inverting the 10-year AA corporate bond rate, currently 2.64% “equal” to a P/E of 38. Apply the 2/3rd’s safety margin and an investable P/E is 25. Of course there must be an unstated implication/assumption that interest rates will stay this low for a significant portion of the 10-year period.
Or, if you have 3 hands, there is TMF1000’s method of capitalizing cash flow, but subtracting capital expenditures–on the theory that these are necessary expenditures to keep the business running. But in the case of the retailer expanding with new stores, the expenditures are not of that nature.
Rules made to be broken…
But, are there any useful rules of thumb for evaluating P/Eis of growth companies growing in excess of 20% per year???
KC
3 Likes
Say a retailer is profitable but earnings are low because cash flow from operations are being invested in expansion. It is growing 20% per year without taking on debt. It is trading at a P/E of 40 and analysts and bloggers say it is overpriced.
Not all money spent on expansion is good investment. It depends on how well or how sparsely the market is already covered. Each type of retail business has an optimum number of stores it can open. Eating places support more stores than, say, shoe vendors. If a retailer has a concept that can be replicated successfully across markets and has a low store count then you can expect the expansion to be profitable. Once the market is saturated the additional stores can be a costly mistake. At one point Starbucks over expanded and had to backtrack. I like retailers that have a low store count.
My rule of thumb is that 15 is an average P/E ratio, traditional industries can be had around P/E 5, good retailers around 25 and fast growers double or more that. But first you have to check that there is room to grow, not just how fast they grew in the past. And you have to check that the company is truly a growth medium.
The “S” curve is a good representation of growth. The bottom of the “S” (the curve in the hockey stick) is formed when about 15 to 20% market penetration is achieved. The top is formed at 80 to 85% market penetration. The best time to hold the stock is the middle period.
The “S” curve: https://www.google.com/search?client=safari&rls=en&q…
But, are there any useful rules of thumb for evaluating P/E is of growth companies growing in excess of 20% per year???
I believe Peter Lynch had such a rule of thumb but I don’t know it.
Denny Schlesinger
3 Likes
Thanks Denny, for constantly shearing your knowledge as a savvy investor.
Maria, who’s learning this fine art of investing!
Oforfive -
Chapter 10 of Lynch’s “One Up on Wall Street” has an excellent discussion of the p/e ratio.
As you point out PEG is just a heuristic and further analysis is always required.
My favorite hunting ground is for stocks with established growth rates in the 15-20% range with mid teens p/e rations. You won’t find many of those in the current market. I become cautious when the p/e ratio goes over 30, that often implies very high growth rates over numerous years. Few companies have achieved that. I do own a couple of those right now, BWLD is one.
I would also be cautious about companies investing heavily in unproven business models. Yes that could be a reason for a high p/e but it also may just mean the business will never be that profitable.
sw
2 Likes
Thanks Denny, for constantly shearing your knowledge as a savvy investor.
My pleasure! But not savvy, just older, meaning I made my mistakes earlier. 
Denny Schlesinger
4 Likes
Thanks from me too. I’m also older and still “learning” from my mistakes far too often. In spite of that, my investments are doing pretty good. I’m hitting about 9% across all my investments for 1Q15. I won’t be disappointed if I keep that pace going all year. I credit Saul, yourself and other contributors to this board for a lot of my success. Even the less experienced folks are helpful for the questions they ask. And to be honest and give credit where credit is due, I owe a debt of gratitude to TMF. Many of the best performing companies I own were originally TMF recommendations.
3 Likes
Stillwater,
Are you using GAAP or Non-GAAP to determine PE just out of curiosity?
Or are you taking PE from a source and do you know what they use? I presume GAAP if it is from a source.
Thanks,
A.J.
I would generally use GAAP, but every company/situation may be different. I often rely on the Value Line numbers, but they are not always correct, so some further digging/analysis can be required. One must use some thought with one time items (are they really one time) etc.
sw
I suspect if there was any simple one rule fits all, everybody would use it and any advantage would be swiftly arbitraged away.
And anything entirely rule based can always be done faster and better by computers. Some business will grow fast for a long time (Microsoft) some will grow equally fast then collapse (Pet Rock)