Should You Ever Buy a Mature Company at a P/E of 30?

A number of very large mature companies are presently trading at price/earnings (P/E) ratios in the range of  30.

Costco trades at 31 times trailing earnings and Visa at 28 times. This compares to the S&P 500 which is trading at 23 times trailing GAAP earnings and 21 times trailing operating earnings. It also compares to the S&P 500’s historic long-term average trailing GAAP P/E of 16.

Costco and Visa are both exceptionally strong companies with tremendous competitive advantages. It seems a safe bet that both will continue to grow their earnings over the next ten and twenty years.

But the question arises as to whether it makes sense to pay as much as 30 times earnings for the likes of Costco and VISA or other high-quality large mature companies.

An analysis of Costco’s potential returns:

Let’s take a look at the the potential returns that might result from from buying Costco at 31 times earnings and holding it for the longer term.

Costco is unquestionably a wonderful business. Its return on equity has been steady at about 20% for the past four years. It has very significant cost advantages over competitors. Its revenue per share growth in the past ten years has averaged 7.8% annually and earnings per share have grown at an average of 8.7% annually. Costco is in a predictable non-cyclic business. Costco has the ability to continue to add stores internationally. Given its stability and cost advantages it seems reasonable to conclude that Costco will continue to grow and prosper over the years. Nevertheless, its P/E ratio of 31 presents challenges to investors expecting to make an attractive return by buying and holding Costco’s shares. Costco currently pays out a reasonably generous 33% of its earnings but this translates into a dividend yield of only 1.1% because the stock trades at 31 times earnings.

Here are some scenarios:

Imagine that Costco continues to grow earnings per share at 9% annually. In this case, if the P/E remains at 31 then an investor’s return, over any period of time, would be about 10% annually (9% from capital gains and about 1% from dividends). A 10% annual return is very attractive given today’s low inflation and interest rates. An investor can grow quite wealthy over a lifetime based on a 10% return.

However, given that Costco’s P/E seems likely to regress toward the market average in the long term, this 10% compounded annual return is arguably at the very high end of what could be expected from a long-term investment in Costco.

Imagine that the P/E falls to 20 over a twenty year holding period. The decline in the P/E means that the final price will be 35% lower than in the P/E 31 scenario. In this case while the earnings still grew at 9% annually, the 460% gain in earnings becomes only a 261% gain in the stock price. The stock price would only have compounded up at an average of 6.6% annually. The dividend yield would rise to about 1.7% at year twenty (due to the lower price) and the total return would be about 8.0% annually. That is still a good return but not nearly as good as a 10% return when compounded over 20 years. The lesson here is that a significant P/E decline has a fairly substantial impact on the annual return even it occurs over a very long holding period such as 20 years (and this assumes the earnings growth remains unchanged).

And imagine instead that the P/E falls to 20 over a shorter ten year holding period. The ending price would again 35% lower than in the P/E 31 scenario. In this case while the earnings would still grow 9% annually, the stock price would only compound up at an average of 4.3% annually. The dividend yield would rise to about 1.7% at year ten and the total return would be about 5.7% annually. That is not such a bad return but it is far less attractive than a 10% annual return.

And imagine if the P/E fell to the market average of 16 over a ten year period. In that case the 9% annual earnings growth would result in only a 2.0% average compounded increase in the stock price. With the P/E falling by almost half, most of the earnings growth is offset by the P/E decline.

The lesson here is that a significant decline in the P/E ratio over a period of ten years can very significantly lower the achieved return. And, if a P/E decline occurs over a very short period of time it can of course result in a decline in the share price, and a negative return, despite robust earnings growth.

A realistic scenario for a company like Costco is that over say a ten or twenty year period its earnings per share growth will decline from the 9% range to something lower, such as 5%. This would almost certainly be accompanied by a decline in the P/E ratio.

Imagine that the earnings growth averages 6% over the next ten years and that the P/E declines to 18. In this case the earnings would grow by 79% over the ten years. But the P/E decline, in isolation, would lop 42% off the stock price for a total stock price gain of just (1.791 times 18/31 = 1.041) 0.4% per year. In this case the dividend payout ratio might also increase as the growth slowed and so perhaps the total return might be 2.5% per year.

The lesson from all of the above is that a stock like Costco at a P/E of 31 is pricing in a continuation of fairly robust earnings growth. There are a lot of scenarios that would result in only poor to modest returns from Costco going forward. There are some scenarios where an investment in Costco could return about 10% per year for five to ten years. But there are probably no scenarios where Costco could realistically provide an exceptional return such as 15% over the the next ten to twenty years.

My conclusion is that Costco, despite being a wonderful business, (and probably most large mature companies) are not very attractive investments when their P/E is near the 30 level. That is likely no surprise. But the math above demonstrates why this is the case.

When it comes to high PE stocks, it is sobering to realise that a decline in the P/E ratio by one third (say from 30 to 20) would entirely offset a 50% gain in earnings.


Shawn Allen

InvestorsFriend Inc.

February 6, 2017