Why A 15 P/E Ratio Is Fair Value For Most Companies

To me, fair value, as it relates to common stock investments, is manifest when the current earnings yield provided by the company’s profits compensates me for the risk I am taking by providing both a realistic and acceptable return on my invested capital. Most importantly, as will be explained later, current earnings yield and its relevance to fair value is independent and/or separate from future growth.

The Importance of Current Earnings Yield

When referencing my definition of fair value, it’s important to focus on the concept “current earnings yield.”There a couple of reasons why I feel this is both rational and important.  First, the current earnings of a given business are typically accurate within reason (reported earnings). Therefore, the calculation of the return that the current earnings are offering me can be more accurately calculated than if you were using future estimated earnings. To clarify a little farther, after years of extensive research and experience, I have determined (or at least satisfied myself) that a P/E ratio of 15 represents fair valuation for most (but not all) companies based on realistically achievable growth rates.

The 15 P/E Ratio Reflects Fair Value Under Real-World Circumstances

After examining thousands of companies over several decades, through the lens of the FAST Graphs (Fundamentals Analyzer Software Tool), I have observed that a 15 P/E ratio represents historical fair value for earnings growth up to 15% per annum. Although there are exceptions to every rule, it is no accident that a 15 P/E ratio is so ubiquitous. There are logical factors and real-world evidence that support a 15 P/E as a rational fair valuation for most, but not all companies.

First, I believe that it is not a coincidence that the more than 200-year average P/E ratio of the S&P 500 has been between 14 to 16.  Second, this is a real-world occurrence because I believe it also represents and is consistent with, the long-term average return of 6% to 8% that common stocks have traditionally delivered to investors.

This fact is further supported by the reality that a 15 P/E ratio represents an earnings yield (E/P) of 6.67% or approximately 6% to 7%. My point being, that this is a rational and realistically achievable rate of return commonly found in the real world of stock investing. But I believe the most important point regarding this 15 P/E concept rests on the notion of soundness, not rate of return as I presented in part 1 found here. When the current earnings yield is between 6% and 7%, the investment is currently prudent whether (or not) the business grows, and almost regardless of the company’s rate of growth (up to a point – 15%).

But perhaps most importantly, future earnings growth is uncertain. Consequently, it may or may not come out as forecast. Therefore, it makes more sense to focus more on current time than it does future time. Nevertheless, as presented in part 1, the 15 P/E ratio represents a reasonable assessment of fair value for most companies because this valuation threshold has applied to most companies in the real world. In part 1, I presented 3 examples with different growth rates that clearly illustrated a backtest supporting the veracity of the 15 P/E ratio.

Fair Valuation Is A Measurement of Soundness and Prudence

I understand that it would seem logical to assume that a faster-growing company would be worth more than a slower-growing company. In other words, command a higher P/E ratio. However, that would only be true if the P/E ratio was a determinant of return. As I’ve been pointing out, it is not. Instead it is simply a measurement of soundness. The future growth of the business will be the primary determinant of return assuming the business was purchased at a sound valuation (the 15 P/E ratio or 6 ½ to 7% earnings yield for most companies) in the first place.

Moreover, I will further offer and contend that there is a logical reason why the growth rates on what I am calling the average company are represented with a rather broad range. That range is from 0% earnings growth up to 15% earnings growth. This notion is built on the reality that any future stream of income, whether it grows or not, is worth a reasonable multiple. To be as clear as possible, I am suggesting, based on years of experience, that the fair value multiple will often equate to a P/E of 15 (earnings yield 6%-7%) with regards to publicly traded common stocks, and private businesses for that matter.  Therefore, a 15 P/E ratio represents a prudent benchmark of soundness, not a perfect benchmark in all cases, but a rational and sensible valuation level.

The Key: A Win-Win for Both Buyer and Seller

The key to understanding this is to think of it from both the perspective of the buyer and/or a seller. Starting with the seller, it is only rational to sell your business if you can generate enough funds to earn an acceptable return on your proceeds. Allow me to offer the following allegory in order to establish the veracity of this claim.

Let’s assume that you owned a business that was generating you $100,000 per year of net-net net income. Furthermore, let’s assume that the $100,000 per year was both fixed and guaranteed. But let’s further assume that it was now time for you to retire and sell your business. The seminal question is, what price would you be willing to accept from me if I were a potential buyer?

If I offered you $100,000 (P/E = 1), you would (or at least should) without hesitation turn me down because you would know that in one year’s time you would be broke. However, if I offered you $1,500,000 (a P/E of 15) you might consider selling. Since I am attempting to introduce a principle here, we will assume that there are no taxes or costs associated with the transaction. As a result, if you invested the $1,500,000 proceed and received a 6.67% return (the earnings yield from a P/E of 15) your income would be $100,500 per year, or approximately what the business was earning you.

Nevertheless, and, even assuming there were taxes, this transaction might still be rational. Therefore, let’s assume you paid 20% in taxes, brings your proceeds down to $1,200,000.If you invest this money at 6.67% you would be earning $80,040.Although this is less than the $100,000 the business was generating, you had to work to earn it. If you invest the proceeds passively, you no longer need to work in order to get the income, even though it is slightly less.  In simple terms, the best transactions represent a win-win for both parties. Moreover, the best transactions are rational for both parties as well. The opportunity for both the seller and the buyer to win is the essence of why a P/E of 15 is both rational, normal and most importantly, sound.

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Disclosure: Long TGT

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks ...

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