Part 3 in a series of tutorials on value investing: Using the 5 Year P:E ratio to level the playing field and identify undervalued opportunities.
Part 1: My Investment Philosophy
Part 2: The General Store
Part 3: The 5 Year P:E
Part 4: Hitting The Books
Part 5: How To Find Winning Stocks
Part 6: When To Sell
Putting A Price On Growth
Companies want to grow. They want to launch new products, open new stores, explore new markets. And their investors want them to grow as well.
That’s because a company’s value is not based so much on what it is earning today, but on what investors expect it to earn tomorrow. This is why the NASDAQ index traded at an average p:e of 80 at the peak of the dotcom boom and why investors are sometimes willing to pay p:e multiples in the triple digits for the latest hot stock of the day. They are looking ahead 10 or 15 years down the road and imagining the giddy heights to which profits might climb in the future.
In our General Store example, we decided that paying 30 times earnings seemed like an excessively high price to pay for this business. That would give us an earnings yield of 3.3%. If we took the yearly profit out of the business each year and stashed it away in our bank account, it would take 30 years for us to get our money back.
But what if those earnings grew? What if the town the store is located in was gentrifying, drawing in new, well-heeled visitors. What if that simple General Store was seeing steadily improving foot traffic and expanding its merchandise assortment to include higher margin gourmet foods? What if we thought those earnings that we were plugging into our p:e ratio had the chance of doubling over the next few years? Suddenly a p:e of 30 doesn’t look quite so crazy. If earnings did double and our price didn’t change, then the p:e ratio would fall to 15 and our potential purchase price wouldn’t look nearly as extreme.
Growth matters. Ultimately, a company’s value is based not on its current profits or its past performance but on its future profitability. Up until now, we’ve been using current earnings as a proxy for those future profits. But when we’re considering companies that are actively growing, that approach falls flat.
If we’re looking at two companies, and one is forecasted to double its earnings while the other is expected to just tread water, investors will invariably put a higher price on the one that is growing. That is, they’ll put a higher price multiple (a higher p:e) on today’s earnings in the expectation that as earnings rise, the price they paid will look more reasonable against the improved earnings they expect to see down the line.
By focusing only on the companies that have the lowest p:e ratios, we are likely missing out on many, if not all, of those higher growth opportunities.
Generally speaking, the higher the anticipated rate of growth, the higher the p:e multiple you’ll see on a stock. At the extremes, some popular high growth stocks can have p:e ratios above 50 while some no growth laggards can have p:e ratios in the single digits. The important point is that you can find relative value at either end of the spectrum if you know where to look.
The 5 Year P:E
The regular p:e ratio has a blind spot when it comes to growth. But the solution is easy. We can simply use expected future earnings in our p:e formula instead of the current earnings. This levels the playing field and lets us compare the relative value of rapidly growing companies to their slower, more ponderous brethren.
Specifically, I set my sights on what I think a company might make 5 years down the road. To get to that number I start with the adjusted, baseline earnings number that I feel best represents the current earnings power of the company (the same one that I would use for my regular p:e ratio) and then I extrapolate that into the future.
I look at how fast the company has been able to grow in the past and how fast it is growing now. I look at the different avenues by which the company could potentially grow. I consider if there are any natural limits to that growth or if there are any recent signs that growth might be slowing or picking up steam. I take my best guess at predicting the future rate of growth of the company and then I apply that to the company’s current baseline earnings. I carry this forward 5 years into the future and then I calculate the p:e ratio based on that future earnings projection. This gives me what I call the 5 year p:e and it is this number that I use as my final valuation yardstick.
Just as with my original General Store example, I am calculating the value of my investment based on the ratio of my purchase price to the underlying earnings of the company, but instead of using current earnings I am peering into the future and using those anticipated future earnings. As the Canadian hockey player Wayne Gretzky famously said, ” I skate to where the puck is going to be, not to where it is.”
The Limits To Growth
But why 5 years? Why not 10 or 15, or even 20?
Because nothing lasts forever. Markets change. Industries rise and fall. New competitors come on the scene. Old rivals lose their way. New products get introduced. Consumer tastes change. New technologies get invented. Old technologies get made obsolete. The only permanence is change.
There is a correlation between the past rate of growth of a company and its future growth rate, but the correlation is not perfect. And that correlation gets more and more tenuous the further out you go. Studies have shown that growth has a strong tendency to mean revert after 5 years. Rapidly growing companies may see their growth slow down as markets get saturated and competitors move in on their turf. Low growth companies may see their performance improve as painful restructurings get done, new management gets brought in or they pivot into new lines of business. Growth can decelerate or accelerate unexpectedly. More than five years out and your crystal ball becomes increasingly hazy.
Which is why I limit my future earnings prognostications to 5 years. It’s also why I put upper and lower bounds on my expectations. At the top end, I am always careful to rein in my enthusiasm. I’ll limit my expectations of future growth to 15% per year over 5 years, which would work out to a doubling in size, regardless of how spectacularly well the company may be doing at the moment. Likewise, on the bottom end, I try to keep an open mind and not just dismiss out of hand a company that has been struggling to make any headway. Unless the situation looks particularly dire, I’ll usually pencil in a minimum growth rate of 0%, even for companies that have seen their fortunes fading.
Some of the biggest payoffs come from those companies that end up surprising investors to the upside. A company priced as if it was going nowhere can surge in price if they start to exhibit even moderate growth. And a company priced for moderate growth can enjoy a similar windfall if it manages to kick it into high gear.
But this is a double edged sword. The same earnings surprises can sting on the way down. A high growth company, priced for perfection, can see its shares plummet when that growth disappoints. So I stay alert and I stay flexible. If the future does not turn out the way I expect it to, I change my expectations.
Estimating Growth
When calculating growth rates, I always have to bear in mind that the future is highly unpredictable. Given the uncertainty involved, I do not obsess over the growth rate to the nearest decimal point. I’ll often come up with a range of growth expectations that seem justified by the company’s past performance and what I know of its future plans. My estimate might be 3% on the low end and 7% on the high end. When it comes time to calculating the 5 year p:e I’ll just pencil in a round number that falls roughly in the middle of that range.
Typically, I estimate the future growth potential of a company by looking at the past. And somewhat paradoxically, I tend to look far more to the past rate of growth in revenue than I do to the growth in earnings. Revenue is a much more stable measure than profitability. It is not unusual for a company to swing back and forth between making money and losing money, but sales will be far more consistent. You can’t have negative sales.
Furthermore, I look at the growth record of sales per share, not the total sales of a company. Companies can issue shares to raise money to buy growth (by spending that money on an acquisition, for example), but as a shareholder, you are no further ahead if the resulting growth is cancelled out by the increased share count. On the other side of the ledger, companies can grow their sales per share over time by consistently funneling a portion of their profits into buying back their own stock. You would miss this aspect of growth if you weren’t looking at things on a per share basis.
I also adjust past sales for inflation. This is especially relevant if you are looking at the rate of growth during the covid pandemic period when prices jumped by 25%. That 25% gain in the overall price level boosted most company’s sales by a similar amount, but that doesn’t mean those companies were growing in size, the increase simply reflected the rise of inflation.
Finally, I need to make an adjustment for any dividends that may have been paid out. In general, I am a dividend agnostic. That is, I don’t particularly care if a company is issuing a dividend or not. I focus on earnings yield, not dividend yield. As I explained previously, I operate on the assumption that company profits will find their way into my pocket one way or another, be it through acquisitions, corporate expansion, share buybacks or dividends. I leave it up to corporate management to decide which of these options is the best use of company profits. However, in the event that they do choose to issue a significant dividend, I need to factor that in to my calculations.
A dividend payer is going to struggle to put up the same kind of growth numbers as a non dividend payer. If a company is passing out all of its profits to shareholders in the form of a dividend then it has nothing left over to grow the business. However, as a shareholder, you can turn right around and use that dividend to buy back more shares. You are still getting the growth, it’s just not reflected in the company’s results.
To account for this, I typically tack on a few percent to my observed growth rate for companies that are paying out a high dividend.
Beyond that, I’ll rely heavily on a subjective assessment of the company. This is where value investing veers away from being pure science and becomes as much of an art as a science. I need to understand what the company does, where it has been in the past and where it is going in the future to make an accurate assessment of its likely growth rate. I need to know what industry factors might be playing a role in the company’s success or lack thereof. I need to know what the company itself is up to. Is it expanding into other regions? Is it opening new stores? Does it have plans to build a new factory? I’ll look at the year over year rate of growth as well as the growth over longer periods. I’ll look at how growth rates have changed over time. I’ll see if there were episodes of strong growth in the past followed by lulls, or if growth has been smooth and steady.
Finally, I need to know where in the business cycle we are. Have we recently merged form a nasty recession or are we currently in the depths of one? Strong growth coming out of the bottom of a recession or very weak growth heading into one is not what I want to be measuring. I want to measure average growth over a typical business cycle. For cyclically sensitive companies, ideally I want to measure growth from peak to peak or trough to trough.
After all of this, I’ll come up with a rough estimate of what I think the future growth rate of the company is likely to be. Armed with this bit of information I can go about calculating the company’s future expected earnings and its 5 year p:e ratio.
Running The Calculations
In order to precisely calculate past growth rates, you can use the following handy formula:
Annual Growth Rate = (Final Value / Initial Value) ^ (1 / # of Years) – 1
To calculate future earnings based on a given growth rate, 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
Finally, 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
An Example
Let me run an example to show how these formulas might work…
Disposable Plastics Inc. is a mid sized manufacturing company making plastic cutlery for the hospitality industry.
Past growth estimate: Sales per share were $34.27 in 2018. After a dip during the early part of the covid crisis followed by a strong recovery, sales have settled in at $47.50 in 2024.
The annual growth rate was ($47.50 / $34.27) ^ (1 / 6) – 1 = 5.6%.
Meanwhile, the CPI moved from 251.2 at the end of 2018 to 315.6 at the end of 2024 for an increase of (315.6 / 251.2) ^ (1/6) -1 = 3.9%.
The inflation adjusted rate of growth was therefore 5.6% – 3.9% = 1.7%
The company pays no dividend.
The most recent set of trailing 12 month earnings as reported by the company clocked in at $3.35 per share. Those earnings include a legal settlement to cover a payout to someone who stabbed themselves in the cheek with a plastic fork. If we exclude that from our calculations then our adjusted EPS comes in at $3.50.
Therefore, Future EPS = $3.50 x (1.017) ^ 5 = $3.81.
The stock is currently trading at $58. Therefore the 5 year P:E is $58 / $3.81 = 15.2
What does that tell us? On its own, nothing. But in the context of the rest of the market, a great deal.
Value Is Relative
Over the course of your investing lifetime the stock market is likely going to swing wildly from highs to lows and back again. It can be a white knuckle ride at times. At the top of its cycle, average p:e ratios will be quite high as investors bid stocks up to unsustainable levels. At the depths of a market panic, valuations (average p:e ratios) can become disconcertingly low. A 5 year p:e ratio that might indicate a potential bargain in a frothy market can actually look overpriced at the bottom of a crushing bear market.
As I write this at the beginning of 2026, the average p:e ratio of the S&P 500 index is pushing 30, a level it reached only once before, at the peak of the dotcom mania. Meanwhile, at the very bottom of the Great Financial Crisis in the spring of 2009, the average p:e ratio of the S&P 500 briefly hit the 10 mark. And back at the depths of the 1970’s inflationary bear market, it bottomed out around 7.
What constitutes a cheap p:e ratio, one that might indicate potential value, can change dramatically over time as the market lurches up and down. Unfortunately, you can’t predict ahead of time when these market shifts will take place. While it is tempting to try to time these market movements, in my experience it is better to simply search out the best relative values you can find in whatever type of market you find yourself in and ride the waves up and down.
Initially, you won’t have a clear idea of what a typical 5 year p:e ratio might be and what level might be low enough to indicate a potential stock market bargain. But after running the numbers on a few dozen stocks, you’ll start to get a much better sense of that. The goal is always to own the cheapest stocks you can find. Or, rather the stocks with the lowest 5 year p:e ratios that otherwise meet your vetting criteria. Avoid companies with large red flags or big clouds hanging over them and focus on the companies that seem basically sound and that you can feel comfortable holding on to for the long term.
Within those parameters, fill your portfolio with the cheapest of the cheap. Sometimes, when the market has gotten carried away with itself, that might mean you’re holding a lot of stocks with 5 year p:e ratios in the low double digits. Stocks with a 5 year p:e ratio of 11 or 12 might be the cheapest you can find. Other times, when the market is on a more even keel, you should be able to find sound companies with 5 year p:e ratios in the 7-10 range. And if we have a major secular decline in the market like we saw in the 1930’s or 1970’s then perhaps you’ll be able to fill your portfolio with companies sporting ratios in the low single digits.
Apples To Apples
The great thing about using the 5 year p:e ratio as opposed to its more limited cousin, the regular p:e ratio is that it levels the playing field. It makes comparing high flying growth stocks and stodgy, old-line, low or no growth companies possible. A fast expanding retailer might have a regular p:e of 22 while a struggling auto parts manufacturer might have a p:e of 16. The regular p:e would highlight the auto parts company and completely ignore the faster growing retailer. You can’t use the regular p:e to directly compare companies with different growth rates.
But once you factor those growth rates into the equation and calculate their respective 5 year p:e ratios, the two situations become directly comparable. If the market has priced these two stocks accurately, then the 5 year p:e ratios should be roughly similar. If they’re not, that can signal potential value. Using future expected earnings, the rapidly growing retailer might have a 5 year p:e ratio of only 11 (reflecting your expectations that earnings could double in 5 years) while the auto parts company could have a 5 year p:e ratio that is still 16 (reflecting expectations of essentially zero growth). This suggests the retailer is actually the better deal.
I also find the 5 year p:e ratio to be very useful in helping me run through different investment scenarios as I’m considering whether to make an investment. Take that fast growing retailer as an example. I might have calculated a 5 year p:e ratio of 11 based on a projected growth rate of 15%. The company has been expanding its store base rapidly over the past few years, doubling its store count from where it was 5 years ago. If I expected the same rate of growth over the next 5 years then my 5 year p:e of 11 could be signaling an enticing value.
However, if I look at the store count of other, more mature retailers in the same sector, I might see that the company’s existing store count is getting close to that of those other comparables and I might worry that the company could be in danger of stalling out as it saturates the market. If I lowered my growth rate forecast to 5% and re-ran my 5 year p:e ratio calculation, I’d get a 5 year p:e ratio of 17. Not the bargain I was hoping for. Whether I make the investment or not would depend on how likely I thought each of my two different growth scenarios might be.
The 5 year p:e ratio is not the be all and end all of financial analysis. It’s a very useful yardstick for measuring the value of different potential investments or the outcome of different investment scenarios, but it can’t tell you definitively whether to buy a stock or not. That depends on a through analysis of the company, taking into account all the factors that can contribute to a company’s future success or failure.
In other words, the 5 year p:e can lead you to the right neighbourhood, but it is up to you to find the right house. How I go about doing that is coming up next.
It’s this more granular level of detail that I’ll get into next in part 4 of this series, “Hitting The Books.”