How Much Growth Is “Priced-In” To A Given Stock?

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.

Example 1 Example 2 Example 3
Initial Earnings per share $1 $1 $1
Stock Price (=P/E) $20 $20 $30
Required Return 9% 9% 9%
Holding Period, No. of years 2 2 2
Terminal P/E 20 15 15
Calculated implicit growth 9% 26% 54%

Observations:

In the first example, the P/E is not expected to change over the two year holding period. Mathematically, the implicit growth is exactly equal to the required rate of return. The P/E will not change and so the earnings must grow at the same rate as your required rate of return. If you “need” to earn 5% on this stock, then earnings must grow at 5% to deliver that return. If you require a 9% return then whenever you buy a stock, with no dividend, that you expect will have a stable P/E ratio over your holding period, you are implicitly assuming that the earnings will grow at that same 9% . You need to be comfortable that the company is capable of growing as fast as your required rate of return.

In the second example, the initial P/E is 20, but you expect the P/E to revert to a more sustainable P/E of 15 by the time you sell in two years. In this case the earnings must be dramatically higher at 26% each year to offset the reduction in the P/E and still provide your 9% return. The message here is that an impressive earnings growth rate of say 25% per year is no guarantee of high returns, if that rate of growth cannot be sustained and if therefore the P/E can be expected to decline.

The third example shows an ever larger regression in the P/E which therefore drives up the required growth rate. In this example, if the P/E is expected to decline by 50% (from 30 to 15), then the stock is actually “pricing-in” an aggressive 54% earnings growth over the two years. This could occur where the high growth was expected to be quite temporary. This example illustrates the extent to which a P/E contraction is the growth investors worst enemy.

Value investors can estimate the amount of growth that a stock is “pricing-in” under various assumptions about the required return and the terminal P/E and then consider whether or not the stock is pricing in more growth than it would be prudent to pay for.

This analysis is most applicable to established companies with reasonably predictable earnings. The initial earnings has to be a “normalized” earnings (with unusual gains or losses removed) and the company has to be growing in a predictable manner. Highly cyclic or commodity linked businesses are not conducive to this analysis. Companies with negative or abnormally low earnings are also not conducive to this analysis.

For more predictable companies, this method can provide a reasonably easy “dumb check” to insure that you are comfortable with the amount of growth that is “priced-in” and that you would therefore be paying for (in advance) if you bought the stock.

Shawn Allen, Editor April 5, 2002