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Gems Wealth & Economics:
Which of the following two hypothetical companies produces more earnings, per dollar invested, over the next five years?
The answer, believe it or not, is Stock A, according to Steven Check, a value-oriented adviser who edits the Blue Chip Investor newsletter -- and to whom credit goes for this example. As the first step in appreciating the mathematics behind Check's example, consider a $100 investment in each of these two companies. In the case of Firm A, this $100 "purchases" $6.67 of the current year's earnings (which is just the $100 divided by its P/E ratio). In contrast, because Firm B has a much higher P/E ratio, $100 invested in the company corresponds to just $2.86 of current earnings. Of course, this $6.67 in earnings at Firm A will be growing at a lower rate than the $2.86 in earnings at Firm B. But even so, five years is not long enough for accumulated earnings of an investment in Firm B to outpace those for Firm A. In fact, it is not even close. Accumulated earnings over the next five years of a $100 investment in Firm A will amount to $51.44, in contrast to $32.17 for Firm B. Which leads to another brainteaser: How long will it take before accumulated earnings of an investment in Firm B outpace an investment in Firm A? Check's answer: "It's not until year 12 that case No. 2's superior growth allows its accumulated cash earnings to overtake case No. 1's." Of course, this example does not automatically imply that Firm B is an inferior investment to Firm A. But several other things must fall into place in order for Firm B to be a better investment. One big prerequisite for Firm B is that its earnings actually grow this fast, and not just for a year or two but for a dozen years. The odds of that occurring are next to zero, according to Josef Lakonishok, a finance professor at the University of Illinois at Urbana-Champaign. Lakonishok and two co-researchers reached this conclusion by measuring how many publicly traded companies between 1951 and 1997 had their earnings grow at above the median rate for several years in a row. Since, over time, the median growth rate in earnings is less than 10 percent per year, the researchers were imposing a relatively modest requirement, especially compared to Firm B in Check's example, whose earnings are projected to grow at an average annual rate of 25 percent. Nonetheless, Lakonishok and his fellow researchers found that it was extremely rare for companies to grow this fast for five or more years in a row. (Their study appeared last April in the Journal of Finance.) The other obstacle in the way of performing well with an investment in Check's hypothetical Firm B has to do with the typical investor's holding period. If that is just a couple of years or less, which is average, then most investors will not be investing in the company for long enough that its superior growth rate makes up for its sky-high P/E ratio. To put this argument another way: For a short-term investment in Firm B to work out, investors must rely on its P/E ratio staying high. But that's a far different kind of gamble than investing in the company's earnings. Check writes: "If you talked to money managers that pay 35 times earnings for stocks, they'd tell you they're buying into the company's long-term growth prospects. Ironically, these same money managers usually have a stock holding periods averaging less than two or three years." Not surprisingly, the companies that Check prefers are those that are trading for P/E ratios that are much lower than those of Firm B in his example...
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