How Much Growth Is "Priced-In" To A Given Stock?
Summary
To make a long story short, before investing in a stock, solve for the amount
of growth that is "priced-in" to the stock by modeling a (say) two year holding
period and assuming a required rate of return and an assumed terminal P/E at
which the stock will be sold.
Consider if you are comfortable paying for this level implicit growth, if you
believe the actual growth will be at least that high, then you can buy
the stock, otherwise do not buy.
This calculation can help you avoid over-paying for growth.
The formula for a 2 year holding period for a non-dividend paying stock
is
implicit growth = ((stock price * (1+ required return)^2) / (starting
earnings * assumed terminal P/E))^1/2-1
The Details
The essence of value investing is to calculate the "implicit" value of a
stock based on its expected earnings and growth and to then buy stocks that are
trading significantly below their "implicit" value.
Unfortunately, calculating the "implicit" value of a stock requires hours of
effort.
Another way to approach the problem is to consider how much growth is
implicitly priced into a stock and then consider whether or not that growth rate
seems attainable.
Established, profitable companies often tend to trade on a P/E basis. Most
investors realize that higher growth stocks command a higher P/E.
Stocks that trade at a high P/E are implicitly "pricing-in" a certain amount
of growth.
This article explains how an investor can easily calculate the amount of
growth that a stock is "pricing-in". This is very important because investors
are essentially paying for that much growth when they buy the stock. If that
"priced-in" amount of growth actually occurs then the investor should make a
"market-level" return such as 9% which is the market level of compensation for
the risk taken. Of course investors are hoping to make a wind-fall
"above-market" return. The only way this will happen is if the growth turns out
to be higher than the amount of growth that was "priced-in" to the stock
when it was purchased.
For example, a company that is expected to grow at 30% per year is a bargain
if the market is only "pricing-in" a 10% growth rate. But if the market
becomes "irrationally exuberant" and is pricing in 35% growth, then this will
most likely be a very poor investment. In this scenario the growth has to be
even higher than the expected 30% in order for the investor to make a good
return. If the growth turns out to be "only" 20% then the investor will likely
lose money.
The implicit growth rate can be estimated by assuming that after a certain
time period the P/E ratio will revert to sustainable level such as between about
10 and 18. In addition the investor must assume a required minimal
acceptable rate of return.
The formula is:
stock value = present value of dividends + present value of proceeds of
selling the stock after the holding period.
The present value of the dividends and proceeds of selling the stock are
affected by the required rate of return (discount rate), the growth rate in
dividends and earnings and the P/E at which the stock is expected to be sold.
Length of assumed holding period:
A longer holding period such as 10 years has the advantage that we can be
more confident that the P/E will by then revert to a conservative sustainable
level such as 12 to 15. However, a major disadvantage is that it is often very
difficult to judge whether a given growth rate is sensible over that time
period. In many cases a high growth rate would be expected to persist for only a
few years and to then revert to a more sustainable growth rate.
Conversely over a shorter holding period it is easier to judge whether the
implicit growth rate is achievable. However, it is more difficult to judge where
the P/E level will be . A high P/E level can often persist for several years and
it is difficult to judge when it might revert to am ore sustainable level.
For this purpose, I recommend using a holding period of 2 to 5 years. Higher
growth stocks should be evaluated using shorter holding periods.
Example
The formula for a non-dividend paying stock with a 2 year holding period is:
stock price = (beginning earnings * (1+implicit growth)^2 * assumed terminal
P/E) / (1+required return)^2
It takes a bit of math, but we can solve for the implicit growth as:
implicit growth = ((stock price * (1+ required return)^2) / (starting
earnings * assumed terminal P/E))^1/2-1
For a three year holding period replace the 2 and 1/2 by 3 and 1/3, etc.
The following table provides some representative examples for a stock that
does not pay a dividend.