Building A Valuation Framework

Part 4 in a series of tutorials on value investing:  Using the 5 Year P:E ratio to find undervalued opportunities.

Part 1: My Investment Philosophy
Part 2: The General Store
Part 3: The Investor’s Toolkit
Part 4: Building a Valuation Framework
Part 5: Hitting The Books
Part 6: When To Sell

Red Fish, Blue Fish

There are a bewildering variety of companies listed on the stock market. There are technology superstars, blue chip stalwarts, young companies with fresh, new ideas and former industry leaders well past their prime. Retailers, manufacturers and biopharmaceutical start-ups. Global shipping companies, auto parts distributors and fast food franchises. How does one even begin to make sense of this chaotic jumble of opportunities?

For starters, I simply discard from consideration many of the companies that make up the market. Entire sectors of the market get the cold shoulder from me. The resource industries: mining, oil and gas and forestry tend not to lend themselves well to my sort of earnings-based analysis. Exploration companies are beyond my ken. I don’t have the expertise to know if a patch of moose-pasture in Saskatchewan has a high-grade vein of gold lying under it or not. Even the resource production companies give me problems; their fortunes are closely tied to future commodity prices and I have no particular insight into what the price of zinc will be in a year’s time. I do invest in the companies that service the resource industries, though. These seem a bit more amenable to my style of analysis.

The banking and real estate sectors also get a pass from me. Banking is too much of a black box for my liking and real estate companies are priced more on the asset value of their property holdings than they are on the earnings (if any) they might be generating. I ignore biotech as well. I don’t have any idea which experimental drugs may successfully run the long gauntlet of clinical trials to gain ultimate FDA approval, and which will not. Utility companies generally carry far too much debt for my liking.

Any company with a long history of losing money gets a pass from me. My analysis typically centers around a company’s earnings, or more accurately, what I expect its future stream of earnings to look like. And to help determine this, I look to its past record of profitability. Companies that have never made a profit don’t give me anything I can sink my teeth into. I know where my strengths lie and it is not in being a visionary, assessing the impact of paradigm-shifting new technologies or the strength of a company’s network effects.

My analysis is often much more grounded than that. Is the company making money? If so, how much? And how much do I have to pay to get a piece of that action? This means I miss out on many of the hottest investment fads of the day. The glamour or story stocks that make for exciting coffee shop chatter and speculation rarely show up on my screens. And that’s just fine. My stodgy old portfolio has provided me with plenty of excitement over the years. A construction company may not have the sparkle and shine of a biotech company working on a break-through drug, but when the stock price triples in value, it can still get the heart racing.

As a final part of my screening process, I apply a basic test of financial strength. I want total net debt to be less than five times annual earnings. If a company is more highly leveraged than that, I am generally not interested. It may be a great company otherwise, but if it’s carrying a heavy debt load I’d rather take my investment dollars elsewhere.

Apples To Oranges

Even after this extensive winnowing process, there are still a dauntingly wide array of companies to choose from. How do I compare a global car company to a small, regional chain of coffee shops? Or a rapidly growing software company to a struggling newspaper publisher? I need a common valuation framework that I can use to measure and compare these disparate businesses. Something that will let me narrow the playing field and lead me to the companies that have the potential to offer me the most value for my hard-earned investment dollars.

One approach would be to simply buy the stocks that had the lowest p:e ratios, with no effort to discriminate between the good, the bad and the ugly. While not terribly sophisticated, it’s been shown that this approach would have been surprisingly successful over time, outperforming the overall market by a percentage point or two a year. With this approach, you’d end up owning a lot of crappy companies (most low p:e stocks have a low p:e for good reason), but every so often one of them would manage to pull a rabbit out of its hat and the resulting gains would make up for all the losses on the ones that didn’t fare so well.

However, holding on to a portfolio like this would be hard, especially when the market turns south and your portfolio of dogs starts to look increasingly feral. You’d be at risk of losing your nerve and bailing at precisely the wrong time. What’s more, by concentrating on only the lowest tier of the market, you’d be ignoring a lot of interesting and potentially lucrative opportunities higher up the quality spectrum. And by higher quality, I mean companies with higher expected future growth. A market strategy that leaves room to invest in more highly priced, higher quality companies will lead to a more diversified and balanced portfolio and one that will likely perform better in the end, with less stomach churning volatility along the way.

The key to a diversified value investing approach is to not just focus on the cheapest of the cheap but instead to effectively match up price and growth, buying the best combination of those two factors that you can find. A high growth company can be an excellent value at the right price but so can one that is not growing at all. It’s not the underlying growth or lack thereof that makes a good investment, it is the price you pay for that growth. A good valuation yardstick will take growth into account and let you find value priced stocks up and down the quality spectrum.

Putting A Price On Growth

So we need to move away from the simple low p:e approach and add some nuance to the proceedings. If you survey the normal spread of p:e ratios on the street, you’ll find that the p:e ratios displayed by companies with different growth rates follow a reasonably logical progression. Generally speaking, the higher the expected future growth rate, the higher the p:e ratio. Investors are looking ahead and basing their pricing decisions not on current earnings but on their estimate of future earnings. The more earnings are expected to grow in the future, the higher the price the investor is willing to pay today.

But how far into the future are investors willing to look? 5 years? 10? 20? The longer you are willing to extrapolate out current growth rates, the more earnings will compound and grow and the more you’d be willing to pay today to get a piece of those anticipated future profits. Take the example of a company growing at a rate of 15% per year. At that rate, earnings will double in 5 years. In 10 they will quadruple and in 15 years, if nothing derails this juggernaut, earnings would have grown by a factor of 16. If you were to base your earnings expectations on that 15 year projection, you’d expect to see a p:e ratio (using present day earnings) that was many times higher than that of a company with a more pedestrian outlook.

And indeed, that is often what you see in the most popular growth stocks of the day. Investors’ willingness to extrapolate current above trend growth many years into the future explains why some of the popular stock market darlings can sometimes hit astonishing triple digit p:e ratios.

But overly optimistic investor expectations are usually brought back down to earth at some point and horizons are shortened to a more realistic time frame. As expectations are reduced, the share price drops, the p:e ratio comes down, and excitable investors shift their attention elsewhere.

The reality is that the future is highly unpredictable. Company fortunes wax and wane. Economic trends shift. Investor sentiment rises and falls. Any future predictions are going to be rough estimates at best. Trying to predict growth rates too far out into the future is a fool’s errand.

In my experience, five years seems to be the sweet spot for stock market prognostication. This is a reasonable time frame to use when making your growth determinations and seems to be the time frame that is most commonly reflected in the normal spread of valuations that you see in the market (ignoring the occasional outburst of market euphoria). Beyond 5 years, the crystal ball starts to get increasingly cloudy.

Where growth is concerned, there is a strong tendency towards reversion to the mean. Weak companies are heavily incentivized to get their acts in gear. New management is put in place, painful restructurings are done, new markets are explored. Sometimes it’s just a matter of the economic tides changing direction. Likewise, any run of strong growth is always at risk of getting cut short by new products, new competitors, saturated markets or changing consumer tastes. Nothing on Wall Street is forever and so I assume that after a period of about 5 years any currently observed above or below trend growth will tend to converge back to the long-term market average.

This baseline assumption makes my job of valuing stocks a lot easier. I do need to factor growth expectations into my calculations, but I don’t have to tie myself in knots trying to figure out what might happen 10 or 15 years down the road. The next few years is all I can really hope to see with any degree of clarity. Beyond that, current high-flyers may flame out and come crashing back down to earth while market laggards can overcome their challenges and go on to become the future market darlings. I’m looking into the middle distance, about 5 years out, and basing my valuations on that outlook.

The 5 Year P:E Ratio

The easiest way to do this is to simply base our p:e ratio not on current earnings, but on what we expect the company to earn five years down the road. Doing this elegantly combines our earnings estimates and our growth rate expectations into a single number that we can then use to compare different companies with very different growth prospects.

Setting a 5 year time limit on your forecasting ability puts an important brake on the natural tendency to get caught up in the latest market success stories. Equally important, it forces you to take a second look at companies that are currently struggling. Five years from now, the success stories may be facing difficulties of their own and the weaker companies may have turned the corner and be headed back up.

To calculate the 5 year p:e, you divide the stock’s current share price by what you expect its earnings per share (EPS) to be 5 years down the road.

5 Year P:E = Current Share Price / Future EPS

And to calculate those future earnings you multiply the current earnings by (1 + annual growth rate) five times. A company earning $2 per share today and growing its EPS by 15% per year would be expected to grow its earnings to $2 x 1.15 x 1.15 x 1.15 x 1.15 x 1.15 = $4, five years later. If you were using exponential notation, you’d write this as…

Future EPS = Current EPS x (1 + growth rate) ^ 5

Let’s take the example of two different companies, both with a share price of $20 and both currently earning $1 per share. Both of these companies would have a current (also called trailing or trailing 12 month) p:e ratio of 20 ($20 / $1). However, we think company A has excellent growth prospects and we expect it to double its earnings over the next 5 years. Conversely, we see that company B is having difficulties and we do not expect to see any earnings growth in the near term.

Both companies have a trailing p:e of 20, but company A has a 5 year p:e ratio of only 10 ($20 divided by our expected future EPS of $2 = 10) while company B has a 5 year p:e ratio that remains at 20 because its earnings are expected to remain unchanged.

Using the 5 year p:e ratio instead of the trailing p:e ratio, it becomes much more apparent that the high growth company, with a significantly lower 5 year p:e ratio, offers the better value. My model assumes that growth rates all tend to revert to the mean after about 5 years. Therefore I would expect 5 year p:e ratios to also tend to converge on a mean and any stock with an unusually low ratio represents a potentially undervalued situation.

Here’s where the opportunity lies. Assuming that your growth estimates turn out to be accurate, if you find a stock whose 5 year p:e ratio is significantly below the market average, that is an indication that the company may be mispriced. It shows that other investors have a very different estimate of future earnings growth than you do.

At this point, it’s time to roll up your sleeves and get to work. Other investors are not stupid, and it may be that it is not the stock that is mispriced, it is your expectations that are way off base. You need to do your research and double and triple check your assumptions. If you are still confidant in your own estimates after doing your homework, then it’s time to bet on the home team. Value investing is about identifying those situations where your outlook diverges significantly from the herd and then betting that you’re right and everyone else is wrong. It happens more often than you’d think.

I recently did one of my periodic reviews of the market. I went through a list of about 400 small cap stocks, analysing them and forming opinions as to their estimated baseline earnings and growth rates. With these two pieces of information in hand, I could calculate the 5 year p:e ratio for each stock, using my own earnings and growth assumptions. I then graphed these numbers as a histogram to see how the 5 year p:e ratios were distributed.

As you can see, in this market environment, the 5 year p:e ratios tended to cluster around the 14 mark. By zeroing in on those companies that were trading significantly below that number, ideally with 5 year p:e ratios in the single digits, I could pinpoint value-priced opportunities that the market may have overlooked. You can also see that many stocks were sporting 5 year p:e ratios well above this level. That is not too surprising. I always err on the conservative side in my estimates. The outliers on the right side of the graph indicate companies where investors are forecasting future growth rates that are far in excess of my own more skeptical outlook. I would suggest that often those other investors are being overly optimistic. (And will end up paying the price for their exuberance.)

The 5 year p:e ratio gives us a quick and easy tool that we can use to sift through the market looking for cheap, undervalued stocks. Because a low 5 year p:e can be found in both high growth and low growth situations, we can once again resort to simply searching for stocks with the lowest (5 year) p:e ratios and we don’t have to worry that we’ll just end up with a bunch of struggling, low-growth companies in our portfolio. (The way we would tend to do if we focused only on the trailing p:e.) A high growth company that has been underpriced and a low growth company that has been equally underpriced will both have similarly low 5 year p:e ratios and will both get called to our attention as we search the market for bargains.

Fair Value

After playing around with 5 year p:e ratios for awhile, you’ll start to get a sense for what a normal ratio might be for the kinds of stocks you’re looking at. As the market rises and falls, this number will rise and fall as well. Whatever the average level is currently, you’re looking for stocks that are trading significantly below that, hoping they will narrow the gap over time. If the average stock is trading at a 5 year p:e ratio of 14, for example, then you might try looking for stocks with 5 year p:e ratios below 10.

The level you expect a stock to trade at, based on your analysis, is known as its fair value or intrinsic value. In the example above, the fair value of a typical stock, using its 5 year p:e ratio as the measuring stick, would be 14. Any stock with a 5 year p:e ratio below this level could be said to be undervalued.  The discount to this fair value is known as the margin of safety. The idea behind the margin of safety is that the discount you’re buying in at provides a cushion in case things don’t turn out quite as well as you expect.

Generally speaking, you want as big a discount as possible in the stocks you buy. I try to shoot for a 40% discount in my own trading. Thus, if the average stock is trading at a 5 year p:e of 14, I’d be looking for companies with 5 year p:e ratios of 8.4 or less. The bigger the discount, the bigger the potential profit. The valuation gap acts like a magnetic force, inexorably pulling your stocks higher. It often doesn’t happen right away. The valuation gap between your stocks and the rest of the market can be maddeningly slow to close at times, but if you’re patient and if your growth expectations turn out to be correct, the odds are good that you’ll ultimately be rewarded.

The Taxonomy Of Growth

The numbers you feed into your value formulas obviously have a huge impact on the answers you get back out in the end, whether you use the complicated “discounted cash flow” models that professional analysts favour or the more intuitive and straight-forward (in my opinion) 5 year p:e ratio approach that I advocate.

In either case, an accurate growth rate assessment is an essential part of correctly valuing a company. A rapidly growing company can easily be worth twice as much or more (on a trailing p:e basis) than one that isn’t growing. Your assessment of growth matters.

But growth can be a slippery fish to get a handle on. Just as the baseline earnings figure I use is open to interpretation and adjustment (more on that in the next chapter in this series), so too is my estimate of future growth. This is what makes investing as much of an art as it is a science. There are a lot of factors that are going to determine a company’s rate of growth over the next five years and many of them are unpredictable.

Because growth can be so difficult to pigeonhole with any degree of accuracy, I often find it very helpful to conceptually divide the market up into broad growth categories, rather than try to pin my growth estimates down to the nearest percentage point. Humans excel at pattern recognition. We look for repeatable patterns to make sense of large seas of numbers. This is why I find it much more useful to think in terms of general growth categories like “no growth”, “average growth”, or “high growth” instead of in specific growth rate numbers like 2%, 6%, or 17%.

During my periodic market reviews, even after I’ve weeded out the many companies that don’t meet my basic criteria (those with too much debt, those that are unprofitable or those in sectors like mining exploration or biotech that I routinely avoid), I’m still left with a universe of close to 1000 stocks that could potentially offer an opportunity for investment. That’s an awful lot of companies to get your head around. I can’t be doing a detailed growth analysis on each and every one of those stocks or my mountain bike would never make it out of the shed, so I frequently fall back on four basic growth categories to frame the stocks I’m looking at and simply try to place each of the stocks I come across into one of those 4 broad categories.

By framing the investment universe in this way, I can turn the overwhelming complexity of the market into a much more manageable handful of menu options. It’s easy to get lost in the weeds, constructing increasingly complicated financial models on your prospective investments. By aggressively simplifying and distilling the universe of stocks down to a few basic categories, I can more easily see the forest for the trees and get to the essence of the value opportunity that may or may not be presenting itself.

These are the four basic growth categories that I typically divide the universe of stocks into…

Growth Category	Growth Rate Assumption	5 Year EPS Growth	Growth Multiplier
No Growth	0% per year	0%	1.0
Average Growth	5% per year	30%	1.3
Compounder	10% per year	60%	1.6
High Growth	15% per year	100%	2.0

Once I know which growth category I’m going to put a company into,  I can dance between the current or trailing p:e and the 5 year p:e with relative ease by using the growth multipliers in the table above. Of course, I can always calculate the 5 year p:e from scratch using whatever growth rate I like, but by sticking to these broad categories and memorizing the corresponding multiplier numbers, I can make a pretty simple calculation even simpler.

For example, if I think I am looking at an average growth company, expected to continue to grow at the rate of 5% per year over the next 5 years, then I can calculate the projected future earnings by multiplying today’s earnings by 1.3 (In other words, at this rate, earnings are expected to grow by 30% overall. $1 x 1.05 x 1.05 x 1.05 x 1.05 x 1.05 = $1.30). I then use that future EPS number, along with the current share price, to calculate the 5 year p:e. For a high growth company, I’d multiply the present day earnings by 2. For a compounder, I’d multiply them by 1.6.

I can also work directly with p:e ratios. Except for the “no growth” category, the 5 year p:e is always less than the current p:e because the ‘e’ part of the equation has grown. If I know the 5 year p:e I can calculate what the trailing p:e would be by multiplying the 5 year p:e by the corresponding growth multiplier. An average growth company with a 5 year p:e of 15.4 would have a trailing p:e of 15.4 x 1.3 = 20. To go the other way, I divide. An average company with a trailing p:e of 20 would have a 5 year p:e of 20 / 1.3 = 15.4.

Working with these 4 basic growth profiles and the associated multipliers makes my job embarrassingly easy. Deciding which category to slot a company into adds a bit of complexity to the proceedings but not too much. Here’s how I go about doing that…

Average Growth

Growth Category	Growth Rate Assumption	5 Year EPS Growth	Growth Multiplier
Average Growth	5% per year	30%	1.3

To qualify as average, I am looking for companies that are growing at the average historical rate of around 5% a year over inflation. This has been the average rate of corporate earnings growth over the last 50 years. At that rate, once you adjust your numbers for inflation, you’d expect the company to have roughly doubled in size over the past 14 years. If you were to look back at the company’s results from 14 years previous, you should see that sales, earnings and book value were all roughly half of what they are today.

Looking forward, if growth continued at this same pace, you’d expect EPS to grow by another 30% over the next 5 years and that’s the number you’d use for your 5 year p:e calculation.

When looking at past growth rates to guide your estimates of future growth you ideally want to measure from similar points in the business cycle. Many an investor has been tripped up by measuring growth from the bottom of a recession or downturn to the top of the following cycle and then extrapolating this number forward. But measuring from the bottom will heavily skew your results.

In assessing past growth, we want to get a number that’s representative of how fast the company can grow over a full business cycle. While I’m willing to project this growth rate only 5 years into the future, that doesn’t mean that I always use the past 5 years as my guideline. I want a sense of how quickly the business is growing on average as the best guide to how quickly it might grow on average in the future.

Frequently though, you simply don’t have the data you need to make a proper assessment. The company may have gone public near the bottom of the last recession and so you don’t have the option of going back and measuring performance from a period before the downturn. Or, it may have just gone public a couple of years ago and you don’t have any long-term data at all!

This again is where it is helpful to have a few broad growth categories to fall back on. There are certain characteristics common to the high growth, average growth or no growth companies. If a company looks like a duck, quacks like a duck and swims like a duck then it is probably a duck, whether or not you have the historical data to prove it or not. Failing that, my average growth bucket is my default. If I’m not sure what kind of company I’m dealing with, I assume it’s average.

Even with a full set of historical data in hand it may still be impossible to be too precise with your growth rate estimates. If sales have climbed by 8% a year over the last business cycle while earnings have risen by 5% and book value has climbed by 3%, then what is the growth rate? What if earnings have grown by 8% a year over the last 10 years but more recently growth has slowed to the 4% mark? All those different growth rates could paint a very confusing picture if you were trying to nail growth down to the nearest percentage point. And they are all backward-looking. The next 5 years is likely to be somewhat different again.

You can’t possibly predict the future with any real degree of accuracy. Pretending to try is not worth the time and effort. When using the 5 year p:e ratio, I can get as specific as I like with my projected growth rates. But much more frequently, I simply take the mid-range of whatever growth category I’ve slotted a company into and use that. Taking a step or two back, we can see that all those different growth rates I reeled off in the two paragraphs above are converging around the 5% mark, which would qualify this company as an average growth sort of situation. Anything between 2.5% and 7.5% (over and above inflation) would be sufficient to put a company into my “average growth” basket. Provided nothing significant has changed at the company recently (and that’s something I always have to be on the lookout for) then predicting a continued growth rate of 5% or so a year, for the next few years at least, would seem to be a reasonable expectation.

I always use per share numbers for my growth rate calculations to adjust for share buybacks and new share issuance. In the modern era of large and frequent share buybacks, this has become absolutely essential. As well, with the surge in prices during covid, I’ve started adjusting all my numbers for inflation. You can download historical CPI numbers from the internet quite easily or else use an online inflation calculator. Any time period that includes the inflationary boom of the covid era is going to benefit from an inflation adjustment.

Another important thing to watch out for is a high dividend payout ratio. If a company has been dividending out most of its earnings to shareholders, it is unreasonable to expect it to also be able to reinvest in its own growth. So a high payout ratio (which measures the percent of earnings that are paid out as dividends every year) can get a company into the average growth category even if earnings appear to have flat-lined. The way I adjust for this is that I multiply the payout ratio by the market average growth rate of 5% and add that number to my observed growth rate. So if the company has been growing at 2% per year but has been paying out half of its earnings as a dividend (payout ratio 0.5), that will add 2.5% (0.5 x 5% = 2.5%) to my calculated growth rate, bringing it up to 4.5% and pushing it from the no growth category into the average growth one.

Even though their growth may be wholly unremarkable, my average growth stocks can still make wonderful investments if I can buy them at a big enough discount. That is, a low enough 5 year p:e. In fact, this category of stock has probably made up the majority of my investments over the years. I’ll often try to tilt the odds in my favour even more by searching out those companies which may have exhibited average growth in the past but have some tricks up their sleeve which could end up surprising investors with higher growth in the future. Maybe they have a pile of cash on their balance sheet or a new product about to be introduced into the marketplace. Maybe they’ve just made a strategically important acquisition. Because the market is not expecting too much out of them, they are less likely to disappoint and may pleasantly surprise you instead.

Because of this potential, and because of the values you can often find here, I like to think of these stocks as not just average but “perfectly average”.

No Growth

Growth Category	Growth Rate Assumption	5 Year EPS Growth	Growth Multiplier
No Growth	0% per year	0%	1.0

Moving down the growth spectrum, I have my “no-growth” companies. These are companies that are just treading water. They don’t pay out much of a dividend so I can’t give them a pass for that. Despite their best efforts, profits have been stagnating or modestly declining for the past number of years. Maybe they are in a slowly dying industry or are struggling with a legacy product that no one wants anymore. Maybe the company is just badly run. For whatever reason, they are going nowhere fast. But every dog has its day. Sometimes they can get their act together and turn things around. Pivot into new lines of business, develop new products, hire more competent managers. If they do, the stock price can soar. I need to be able to buy in at the usual discount to make the gamble worth it, but even a dog like this has its price.

There is an important distinction to be made here between companies that are just treading water and companies that are in freefall. I try to avoid the companies in freefall or in a state of terminal decline. The companies in my no growth category are struggling, but they have not given up the fight. I need to see some hope of redemption, or I’m not interested. I try to avoid companies that are destined for the trash heap.

I’ll often use the no growth category as my catch-all for any companies I don’t like or that come with unusual risks. For instance, companies in emerging markets often trade at a lower p:e than you’d expect, largely because of the geopolitical risk of investing in a company in a country that may not have the same rule of law or shareholder protections. As an easy method of adjusting my valuation downwards to account for this, I’ll just toss it into the no growth pile regardless of what it’s growth rate actually is.

Likewise, if a company is heavily reliant on a single customer or has a crucial patent that is set to expire in the near future, I’ll toss it into the no growth bucket. If it still shows up as undervalued at this lower valuation, then I need to take a closer look and really decide if the low price is worth the added risk. It may not be. Simply because a company shows up as undervalued by the numbers, doesn’t mean I have to take the bait and buy it. I think of it as a helpful suggestion only.

The 5 year p:e calculation for this group of stocks is quite easy. Since I am not expecting any near term earnings growth, the 5 year EPS number is going to be the same as the current EPS number and the 5 year p;e ratio will be the same as the current, trailing p:e ratio.

Unquestionably, the no growth category is a scary place to hang out. But there are quite a few companies out there that fall into this bucket, especially once you adjust away the effects of inflation. So there is lots to choose from in this arena. And because the stories are so unattractive, these stocks can drift down into deeply undervalued territory. Ideally, as you research these companies, you’d like to see some light at the end of the tunnel. Some reason to believe that this company can pull itself out of the doldrums. You need to enter this space with your eyes wide open, but if you do your due diligence there are opportunities to be had down here.

High Growth

Growth Category	Growth Rate Assumption	5 Year EPS Growth	Growth Multiplier
High Growth	15% per year	100%	2.0

Some companies will have a line on something more exciting. Maybe a new technology, process, brand or service that lets them grow at a significantly higher rate. There’s often something proprietary or unique about what they do. These companies can make great investments if you can find them at the right price. To qualify as a high growth company, I am looking for earnings to double (at a minimum) over the next five years.

Since earnings are expected to double over the next 5 years, the 5 year p:e ratio will be exactly half of the current, trailing p:e number.

While these sorts of companies rarely come cheap, occasionally you’ll find one whose growth prospects are being overlooked or underrated by the market and you can get in at a reasonable price. If I can buy in at a significant discount then not only do you stand the chance of getting a nice ride from the p:e ratio re-rating upwards as the valuation gap closes, but there is always the possibility that future growth will exceed my typically conservative estimates or will last longer than the 5 years I have penciled in and that would add further fuel to the fire.

Which is why investors tend to salivate over these kinds of companies. It is easy to get carried away and project rapid growth many years into the future. That’s how a lot of investors trip themselves up and end up overpaying for the latest sexy, high growth stock. Not only do I limit myself to a 5 year time horizon when projecting out future growth rates, I also put a cap on just how rapidly I expect earnings to increase over those 5 years. 15% is the number I use for my projected 5 year annual growth rate for these companies. Some companies are legitimately growing faster than that, at least in the short term, but if they are, I give them no extra credit for it. Over the years I’ve seen too many high-flying companies flame out and fall back down to earth. So I have no category for “even higher growth”. 15% is as far as I’m willing to go.

Compounders

Growth Category	Growth Rate Assumption	5 Year EPS Growth	Growth Multiplier
Compounder	10% per year	60%	1.6

Lying in between the “average growth” segment of the market, which is where you’ll find most companies hanging out, and the relatively rare “high growth” sector, lies a segment of the market that I admittedly have never felt overly comfortable in. I call these the “compounders”. These are companies with a long track record of consistent, above average growth. To put some more specific numbers on it, let’s say somewhere around the 10% per year mark. Their success is often not due to any unique product or service but instead is simply due to consistent and efficient business execution. Often, they will have grown though a steady string of well-executed acquisitions.

If I don’t have confidence that the company can continue to outperform for at least the next 5 years, then I don’t slot it into this category; it gets bumped back down to average growth. Some investors, including a certain famous investor out in Omaha, will try to identify these perennial outperformers by the “moat” they have built around their businesses. I’ve never been able to see those supposed moats very clearly myself, but if the company has a good track record behind it and I see no obvious reason why growth would slow in the future, then I will grudgingly give it extra marks for its superior track record and valuation-wise I’ll slot it in midway between my average growth and high growth categories.

Keep It Simple

My approach to company valuation is fairly simple compared to some of the more complicated financial modelling that professional analysts use, but that’s a strength not a failing. A basic 5 year look-ahead period, combined with my four broad growth categories, gives me just enough nuance to differentiate the market wheat from the chaff without getting too bogged down in the details. Keeping it simple provides clarity and perspective and keeps me from getting lost in the weeds.

I can churn through a long list of very diverse companies and using a financial dashboard that shows me the last 15 or 20 years of company fundamentals, I can come to a quick decision on what earnings number to use as my baseline and what basic growth category I think the stock falls into. Using these two numbers, I can calculate each company’s 5 year p:e ratio and then sort that list to bring the companies with the lowest 5 year p:e ratios to the top. I then go back and take a good, hard look at each of the companies on this short list to see which, if any, might make their way into my portfolio.

My valuation framework may be simple, but the proper implementation of it requires a lot of research, analysis and careful decision making. There’s a lot that goes on behind the scenes. Many companies that initially appear to be undervalued by a basic 5 year p:e calculation, don’t make it past a thorough vetting process. Initial impressions are frequently wrong. You might start your investigations with certain growth rate assumptions but later ratchet down those expectations as you find out more about the company. Conversely, the company might have hidden talents or opportunities that weren’t apparent on your initial appraisal, and these might cause you to raise your estimates. In reading through the company literature, there might be red flags that pop up, like a recent build-up of inventory or pending litigation. These softer, subjective factors are often what make or break a potential investment. My value formulas will help navigate me to the right neighbourhood, but it’s good old fashioned common sense and elbow grease that lead me to the right house.

It’s this more granular level of detail that I’ll get into next in part 5 of this series, “Hitting The Books.”