Tuesday, 14 July 2015

P/E ratios vs. Earnings Per Share Payback

I've been thinking about the historical P/E ratio (ttm) in the context of determining payback period in years. A few comments about the historical P/E ratio:
  1. It's static, and it doesn't factor in time value of money
  2. It doesn't directly factor in future growth (although an argument could be made that it already reflects historical growth)
  3. It's based on GAAP "E", which may not be representative of the underlying business' actual earnings power (especially during years where non-recurring charges are taken)
  4. It results in a simplistic comparison between companies based only on what investors are valuing $1 of earnings for today with little regard for differences between companies.
I happen to think that it's a good conservative metric as a starting point for further research (conservative in the sense that if it gets low "enough", and a company ends up growing future earnings at a higher clip than expected currently as reflected in the P/E ratio, the result could be P/E expansion as investors reprice expectations. The key here is, define low "enough").

I'm going to tie the above into some simplistic examples of companies in the spotlight right now, and look at the math underpinning the current P/E ratio in terms of earnings payback in years.  We can also interpolate the imputed growth rate required by the market reflective of P/E’s being sloshed around today. 

My initial comparison is between two companies.  These two companies couldn't be more different.  One is Dorel Industries, a slow growing, boring consumer discretionary company with operations in three segments: Juvenile products (car-seats, strollers, etc), bicycles (Scwhinn), and furniture.  It has a market cap of about $1B CDN on revenues of $2.7B. Juvenile products accounted for 40% of revenues, bicycles 40%, and furniture 20%.  Dorel is down 20% thus far in 2015, and has basically gone nowhere since 2012.

The other is Netflix.  We all know Netflix right?  Champion of champions.  Bastion of growth.  Up about 100% thus far in 2015.  Netflix has a market cap of about $42.5B on revenues of $5.8B.


For Dorel, under a no growth assumption, the market is basically saying that it should take 12 years for the initial $2.61 in eps to grow to $33.80 (closing share price as of July 13, 2015).

For Netflix, the #’s are just silly.  I note that there are 33 analysts following the stock (really? This is not a joke).  I took the highest analyst’s estimate of $3.21 this year (why should I bother taking the lowest estimate of $.17 as this analyst is obviously stupid <I'm being facetious here>). Under the $3.21 estimate, investors paying $708 today (as of July 13, 2015) have a payback period of 220 years (no growth).

Now, this is obviously simplistic, the question needs to be at what growth rate does the company need to grow eps at over the next 10 years in order to repay the investor in terms of initial earnings purchased?  And then, the next question is, is this “imputed” growth rate too low, too high or just about right?

Here are the #’s for your consideration.  Interestingly, interpolating for g? = 5% for Dorel results in the initial $2.61 in eps purchased paying for the cost of the shares in year 10.  In order for an investor in Netflix to earn his/her initial eps back within the same period, Netflix would have to grow eps at 64% compound over the next 10 years. 

Funnily enough, Dorel pays a 4.34% dividend, so an investor is about 87% of the way there to imputed g? in terms of dividends.


Ticker Price EPS yr 2015 P/E g? P/E yrs
2015 DII.B 33.8 2.61         12.95 5% 12 year payback (assumes no growth)
2015 NFLX 708 3.21      220.56 64% 220 year payback (assumes no growth)
Dorel Annual Cumulative Netflix Annual Cumulative
2015           2.61           2.61 2015            3.21            3.21
2016           2.74           5.35 2016            5.27            8.48
2017           2.88           8.23 2017            8.66          17.14
2018           3.02         11.25 2018          14.22          31.35
2019           3.17         14.42 2019          23.35          54.70
2020           3.33         17.75 2020          38.34          93.04
2021           3.50         21.25 2021          62.96       156.00
2022           3.67         24.92 2022       103.39       259.39
2023           3.86         28.78 2023       169.79       429.18
2024           4.05         32.83 2024       278.82       708.00
2025           4.25         37.08 2025       457.89    1,165.89
2026           4.46         41.54 2026       751.94    1,917.82
        41.54    1,917.82


Thinking rationally here (this is also my problem), which opportunity offers the greater margin of safety?  The slow growing industrial conglomerate facing near term challenges trading at a P/E of 12x ttm earnings, or the "supposedly" super fast growing company in the process of revolutionizing the way the universe will forever watch videos until the end of time, trading at 220x average consensus 2015 estimates?

Personally. I'd rather buy Dorel.  I find that interpolating for g? = 5% a lot more probable than paying through the nose for growth needing to be 64% compound over the next decade. 

A few more gems in the Canadian landscape right now for consideration.  First off, Dollarama, trading at 35x ttm earnings on ttm eps of $2.21 CDN.  Here's the math:

Ticker Price EPS yr 2015 P/E g? P/E yrs
2015 DII.B 33.8 2.61         12.95 5%  12 year payback (assumes no growth)
2015 DOL 78.21 2.21         35.39 26%  35 year payback (assumes no growth)
Dorel Annual Cumulative Dollarama Annual Cumulative
2015           2.61           2.61 2015            2.21            2.21
2016           2.74           5.35 2016            2.79            5.00
2017           2.88           8.23 2017            3.52            8.52
2018           3.02         11.25 2018            4.45          12.97
2019           3.17         14.42 2019            5.62          18.59
2020           3.33         17.75 2020            7.09          25.68
2021           3.50         21.25 2021            8.95          34.63
2022           3.67         24.92 2022          11.30          45.93
2023           3.86         28.78 2023          14.27          60.20
2024           4.05         32.83 2024          18.01          78.21
2025           4.25         37.08 2025          22.74       100.96
2026           4.46         41.54 2026          28.72       129.67
        41.54       129.67

An investor paying 35 x ttm today would need Dollarama to grow eps by 26% compound over the next decade.  Ok, maybe.

Next, Cineplex, which is trading at 40 x ttm.  ok, 2014 was supposedly an off year for them inflating the P/E somewhat as there were a smaller number of box office hits.  I'll give them this and drop the P/E to 35 x "normalized" eps of say $1.37 in a good year.  Here's the math (similar g? as for Dollarama):

Ticker Price EPS yr 2015 P/E g? P/E yrs
2015 DII.B 33.8 2.61         12.95 5% 12 year payback (assumes no growth)
2015 CGX 48.22 1.37         35.20 26% 35 year payback (assumes no growth)
Dorel Annual Cumulative Cineplex Annual Cumulative
2015           2.61           2.61 2015            1.37            1.37
2016           2.74           5.35 2016            1.73            3.10
2017           2.88           8.23 2017            2.18            5.28
2018           3.02         11.25 2018            2.75            8.03
2019           3.17         14.42 2019            3.47          11.50
2020           3.33         17.75 2020            4.38          15.87
2021           3.50         21.25 2021            5.52          21.39
2022           3.67         24.92 2022            6.96          28.36
2023           3.86         28.78 2023            8.78          37.14
2024           4.05         32.83 2024          11.08          48.22
2025           4.25         37.08 2025          13.98          62.20
2026           4.46         41.54 2026          17.63          79.83
        41.54          79.83

An investor paying 35 x ttm today would need Cineplex to grow eps by 26% compound over the next decade.  Ok, maybe.










And last, but not least, Constellation Software, trading at a mere 108 x ttm.  No shortage of fans for this stock.  Here's the math:


Ticker Price EPS yr 2015 P/E g? P/E yrs
2015 DII.B 33.8 2.61         12.95 5% 12 year payback (assumes no growth)
2015 CSU 526.55 4.87      108.12 49% 108 year payback (assumes no growth)
Dorel Annual Cumulative Constellation Annual Cumulative
2015           2.61           2.61 2015            4.87            4.87
2016           2.74           5.35 2016            7.26          12.13
2017           2.88           8.23 2017          10.81          22.94
2018           3.02         11.25 2018          16.12          39.06
2019           3.17         14.42 2019          24.01          63.07
2020           3.33         17.75 2020          35.79          98.86
2021           3.50         21.25 2021          53.33       152.19
2022           3.67         24.92 2022          79.47       231.66
2023           3.86         28.78 2023       118.42       350.08
2024           4.05         32.83 2024       176.47       526.55
2025           4.25         37.08 2025       262.97       789.52
2026           4.46         41.54 2026       391.88    1,181.40
        41.54    1,181.40

And the funny thing about all of this is, whether it's Netflix, Dollarama, Cineplex, or Constellation, they're all pretty much at or close to 52 week highs, so it's obvious that there's no shortage of demand for these names. I wonder how this will all end?

1 comment:

  1. An update on this as of 11th April 2017. total return since this post was written (incl. dividends+splits)

    dorel: 5.34%
    netflix: 121.99%
    cineplex: 9.53%
    dollarama: 61.73%

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