Tuesday, October 9, 2007

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 13.4, which is equal to 7.45% 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 $ 1.00. So, after five years, EPS will come in at $ 0.59. Now, this is the constant $ 0.59 that we will get five years from now. The value of that cash flow today assuming 4.5% discounting rate is $ 0.47. Applying P/E of 13.4, this company is fairly valued at $ 6.34. Currently, earning per share comes in at $ 1.00 per share. If you look at the stock trading at $ 6.00, 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.

Want more investing ideas? You can get it for free by visiting our commentary section at http://www.noviceinvesting.com