Fair Value With Negative Growth

Our investing journey revolves around finding the fair value of
a common stock You can invest in companies that grow rapidly
and lose money On the other hand, you can also invest in
companies in a declining industry, yet you can still make money
Investing profitably does not merely depend on what you invest
in, but rather how much you pay for a given company
Therefore, let’s look at company with negative earning growth
How do we value them? For a 0% growth company, P/E ratio for the
fair value is 134, which is equal to 745% return year in and
year out For negative growth company, P/E ratio should be lower
of course, since it is giving less and less as the year goes by
Let’s try valuing negative growth with the following assumption
EPS growth is negative ten percent for the next five years and
then stay constant EPS for the current year is $ 100 So,
after five years, EPS will come in at $ 059 Now, this is the
constant $ 059 that we will get five years from now The value
of that cash flow today assuming 45% discounting rate is $
047 Applying P/E of 134, this company is fairly valued at $
634 Currently, earning per share comes in at $ 100 per share
If you look at the stock trading at $ 600, you may think that
it is cheap since it is trading at a P/E of 6 But, if you
expect it to have negative growth of negative ten percent for
the next five years, this P/E of 6 doesn’t sound cheap after all
If you expect negative growth, even a seemingly low P/E ratio
does not translate into profitable investment The industry I
can think of right now is the auto industry The US auto maker
has been struggling for years to compete with its Japanese
counterparts Investors has priced in negative growth for quite
sometime now If you look at say GM or Ford, they have been
trading at a seemingly low P/E ratio for several years Until
this year, both of them has been able to post profits This
year, they are all expected to post a loss The moral of the
story here is to watch out for company with low P/E ratio

Tags | assumption, industry, investment, investors, japanese, journey, maker, money, moral, percent, profits, result, story