Is it true that the PEG ratio is a useful guide to associating P/E ratios and growth rates? Or is there a more rational and effective way? Or any way at all?

All multiples are just proxies for the real thing, the DCF calculation

The value of a stream of future profits or cash flows is calculated by taking the sum of said cash flows, individually discounted byt the appropriate discount rate per item, ie., the required or alternative rate for an equivalent investment per item of cash payment.

10+10+10+10+10 in future profits isn’t worth 50, it’s worth less, due to the time lag in getting the cash, and the uncertainty that you might not actually get them. A DCF model is the theoretically correct way of calculating the sum, the value, the price that a rational investor is ready to pay for the right to that stream. It’s theoretically correct but practically impossible and extremely sensitive to several subjective assumptions. Let me stress right away that I strongly recommend you don’t use DCF calculations [unless you really know what you’re doing].

Consider this: An infinite series of 10s (hundreds of years) might be worth let’s say 100 (so just 10 times the annual payment), since 10 per year means a 10% annual return on investment (10/100=10%), a kind of interest rate, which can be compared to your mortgage interest rate for example. Or, that same stream is worth 150 (yes 50% more!), if we’re okay with just getting a 10/150 = 6.67% annual return on our invested money.

It’s part subjective, part objective. The subjective part is whether we ourselves are fine with it on an absolute basis, and it’s our best idea and bet. We don’t have other alternatives. The objective part has to do with the likelihood we can get out of the investment early by selling it to somebody else. If it’s rational to expect so, then that is a good gauge of the actual value, just like when you estimate the value of your house by the price somebody is likely to be willing to pay for your house. 

In our example the DCF-equivalent P/E-ratio is 10x or 15x respectively, for the infinite series of 10s, depending on our return requirement (10%or 6.67%).

The theoretically correct way of calculating the sum of a stream of cash flows is a DCF, and it can be estimated, “approximated” with an earnings multiple, a proxy that is exactly correct under certain circumstances (the 10x or 15x above), and good enough under other.

ALL multiples, be they P/S, EV/S, P/E, EV/EBIT, P/Book etc. are better or worse, more or less robust proxies for the real thing, which is the actual value, the price that will get us a good enough risk adjusted return in the future. The market wisdom over a century or two of stock markets ha shown that paying 15x earnings (P/E=15) has always resulted in a 10% total annual return. It can be explained by applying a constant valuation to the following: annual GDP growth 6%: 2% people, 2% prices, 2% productivity; with constant margins => 6% annual earnings growth; plus 2% more for the exclusive list of better S&P companies => 8% annual earnings growth for the S&P 500; +2% dividend yield => 10% total annual return for the top 500 listed stocks.

That’s on average, over 100 years, or 200 years, for the average company, that grows its earnings by 8% per year, year after year. But what about other companies, with other characteristics, in particular its earnings growth rate, all else equal (ceteris paribus)

How much should you pay for premium earnings growth?

So, a century or two of practical embedded stock market wisdom tells us that with the low, diversified risk of a stock market index, you have and should pay 15x earnings, and then you’ll get a 10% annual CAGR total return:

S&P index: 8% earnings growth, 15x earnings warranted

Company A, same risk characteristics as the average stock (but not the same diversification as an index of 500 stocks), but 7% higher annual growth rate: 15% instead of 8%. How much should you rationally, reasonably pay, and expect others to pay too?

Here’s how I look at it: Over five years, the 7% extra per year amounts to: 40% more earnings growth than the average. If the market is indexed at earnings of 10 in year five, company A will earn 14. If they both are valued at 15x once we get there (assuming that from that point on A doesn’t grow faster, or we don’t care to pay extra if it does since we’re done waiting and paying premiums; we want the benefits up and above the market from that point onward), A is worth 40% more both then and now if we demand the same annual returns from both. So, if the index should be valued at 15x earnings, Company A should be valued at 15 x 1.4 = 21x earnings. That’s 6 points extra for 7% higher growth rate… suspiciously close. Adding just one more year, or the benefit of the doubt for a slightly higher valuation for A due to it’s superior growth, then 1 P/E point per 1% earnings growth rate seems like a nice rule of thumb – within reasonable limits of around 10% premium growth rate.

I’d rather not use that heuristic, but instead doing the maths of calculating a future profit (premium vs the index) at a future point in time from which I don’t want to pay a premium for the potential premium growth henceforth, and using that as my P/E multiple index reference.

10% extra per year for three years yields a 33% premium, so a P/E of 15*1.63 => 20 today

5% extra per year for 10 years yields a 63% premium, so a P/E of 15*1.63 => 24 today

3% extra for 20 years (if you’re daring enough to make precise forecasts for 20 years!) yields an 80% premium => a warranted P/E of 27 today 

More typically you would accept a P/E premium related to extra annual growth for a maximum of about 4-5 years; and then, within reasonable limits, 1% extra annual growth rate corresponds to one P/E unit today.

That got complicated fast!

OK, trust me on this: you should very rarely accept paying more than 100x earnings for a reasonably large company. In that case, you would need three consecutive years of 100% earnings growth (doublings), in order to take the P/E to 50, 25, and finally a reasonable 12.5 (from our point of view three times hence // the market at an 8% clip would go from 15 to 13.9 to 12.9 to 11.9 as an equivalent [close enough to 12.5]), and then ordinary growth from there to make your investment worthwhile.

Conclusions

• When is a Stock Cheap?
• What is Margin of Safety?
• What is Intrinsic Value?
• Does Your Stock Have a Competitive Advantage (Moat)?