This article is the second in a series of articles designed to elaborate on the proper utilization and understanding of the P/E ratio as an important investing metric. Our first article in this series looked at how the P/E ratio could be used to determine overvaluation. With this article we are going to review two companies where each is fairly valued and each has similar current P/E ratios. Moreover, both companies offer yields above 3.5% which is greater than is available on the 30-year Treasury bond (current yield 30-year Treasury bond 3.02%).
Yet even with these similar attributes, almost identical P/E ratios and above-average dividend yields, we intend to demonstrate how Darden Restaurants (NYSE:DRI) offers a much higher potential future total return. Moreover, even though Darden Restaurants starts out with a lower current yield, its long-term total dividend income stream should also exceed that offered by SCANA Corp. (NYSE:SCG). Therefore, even though both of these companies are fairly valued with approximately the same P/E ratio, we will illustrate that Darden Restaurants is expected to grow much faster, and therefore, generate a higher total return and a higher total dividend income stream.
In order to accomplish this goal we are going to properly utilize the P/E ratio as a relative measuring stick. As previously pointed out in the first article in this series, looking at the P/E ratio in a vacuum is an ineffective and mostly irrelevant way to use it. The P/E ratio only brings value to security analysis when it is applied and looked at relative to the past, present and future earnings power of the company or companies being analyzed. The P/E ratio is a measurement of current valuation in the static sense, but it is a more relevant measurement of valuation when looked at dynamically relative to the future growth potential of the underlying business (earnings growth). Because only when the future growth of the business is correctly ascertained does the P/E ratio draw a true picture of valuation.
The P/E Ratio Defined
In our first article in this series we provided three extensive definitions and explanations of the P/E ratio. Here is the link to that article for those interested in digging a little deeper into the definitional side of the P/E ratio. The following are condensed versions of three different ways of looking at the P/E ratio (price earnings ratio).
- The simplest definition of the P/E ratio is the mathematical formula: P/E = Price divided by Earnings.
- This second definition relates to the P/E ratio as a measurement of the cost of earnings: P/E = How many dollars you must pay to buy one dollar’s worth of a company’s earnings.
- This final definition relates the P/E ratio to the time use of money: P/E = How many years in advance you are paying for this year’s earnings.
However and perhaps most importantly, the P/E ratio by itself does not provide an insight into the future return the prospective investment might offer. Instead, the P/E ratio represents a valuable metric that the user can use to determine whether or not the common stock in question is currently prudently priced. In other words, the P/E ratio can be determined to assess valuation, but not necessarily future performance. In order to assess future performance, investors need to look to the rate of change of future earnings growth that they believe the company in question is capable of achieving. In other words, when valuation represents intrinsic value, the future return will become primarily a function of the company’s future rate of earnings growth.
The Underlying Rationale Behind Valuation - SCANA Corp (NYSE:SCG) versus Darden Restaurants Inc. (NYSE:DRI)
The following analysis compares two companies with very similar P/E ratios and very similar dividend yields. Therefore, it is logical to also state that both of these stocks are comparably valued. However, as we will soon see, it is not logical to say that; therefore, they should produce similar future returns. The point being that fair valuation is a function of prudence. In other words, when the stock is fairly valued it simply implies that the price being asked is a rational one for the investor to pay. Moreover, it also implies it would be irrational to believe that the stock could be purchased at a lower valuation. This does not mean it would be impossible to buy the stock at a lower valuation, just that it would be a rare occurrence and therefore unlikely.
The principle behind the above thesis is predicated on the reality that a stream of income has an intrinsic value that is greater than one times the yield. Let’s evaluate this by starting with the extreme and moving to the rational. Let’s assume that you look at an investment with a reliable income stream that you are confident would continue, but that it would do so with no growth. In other words, a fixed income instrument, CDs, bonds or notes, etc., if you paid a PI (price to interest) of one, then your annual yield would be 100%. Clearly, no lender, which is what a fixed income instrument really is, a loan, would be willing to pay you 100% interest per year. On the other hand, a PI of two would mean that your fixed income instrument was paying you a 50% annualized return, etc. These are extreme examples, and ludicrous to think about. However, often the greatest insights come from evaluating the extremes.
This then begs the question: What is a fair or reasonable P/E ratio to pay for an investment with a variable income stream like a stock, or for that matter, what is a fair or reasonable PI ratio (Price to Interest) to pay for a fixed income investment like a bond? If you consider and agree that a historical rate of return of between 6% to 8% is both reasonable and common, then the fair value P/E or PI falls somewhere between 12.5 (cost of 100% divided by 8% return) and 17 (cost of 100% divided by 6% return). Conceptually, this provides insight into the validity and practicality of a historically normal P/E ratio of approximately 14 or 15 (i.e., between the 12.5 to 17 is fair and normal value).
To summarize, the determination of fair value is predicated on the potential yield the investment offers relative to the risk taken to achieve it. Fixed income traditionally offers no growth of yield, but is generally considered predictable and, therefore, safe. Variable investments (common stocks) will typically offer various levels of growth potential, but with lower predictability, and therefore, higher risk. Consequently, even though a variable investment offers growth, because of the higher level of risk associated with that growth, they generally command a similar valuation to a fixed income investment with no growth because of the extra risk taken.
This discussion is designed to add clarity to the notion that different levels of growth can actually command the same level of initial fair value. These principles of valuation predominately apply to levels of growth between zero and 15%. However, extensive studies utilizing our F.A.S.T. Graphs™ research tool on thousands of examples indicate that once growth exceeds 15%, the power of compounding takes over, and therefore, higher fair value P/E ratios apply. Our research has indicated that the PEG ratio formula (price equals earnings growth rate) seems to closely correlate to growth rates from 15% to 30%. Once growth rates exceed 30%, any future growth rates become questionable due to the sustainability of such rapid expansion.
This now takes us to a discussion of the primary determinate of future return. Although fair valuation is functionally related to the amount of risk taken to achieve a given future return, it is not a precise determinant. At its essence, fair valuation is required in order for the appropriate future return to be achieved, but the actual future return will be determined by the future growth rate of the earnings the company is capable of generating. An initial investment at fair or intrinsic value simply, but importantly, establishes the sound foundation upon which future return can be built. To clarify, intrinsic value enables the future return to be achieved, while initial overvaluation reduces it, and conversely, initial undervaluation will enhance or increase future return.
Furthermore, valuation at the end of any time period being measured will also have an effect on total return. In an attempt to crystallize what has been written so far, let us suffice it to say that valuation is always a major consideration when evaluating past and future returns on investment. A beginning overvaluation will lower returns, while a beginning undervaluation will enhance them. Furthermore, where valuation is at the end of the time frame being measured will have the same effects. However, at the end of the day, the primary determinant of the long-term rate of return on a common stock will be the rate of change of earnings growth, of course, adjusted by valuation considerations.
Testing our Hypothesis through the Lens of F.A.S.T. Graphs™
Let’s now turn to our F.A.S.T. Graphs™ research tool to apply and examine these principles of valuation and growth on our two sample companies. To set the stage, we reiterate that both of these companies can currently be bought at almost identical P/E ratios, and both of these companies offer above-average current dividend yields. However, what we will soon see is that the big differentiator between these two companies is the rate of change of earnings growth that each has historically achieved, and more importantly, is expected to achieve in the future.
SCANA Corp. (NYSE:SCG)
SCANA Corp. (NYSE:SCG) is a quintessential example of a high quality regulated utility company in South Carolina. Utilities like SCANA Corp. have historically been slow, albeit reliable growers that primarily attract investors through their dividend yield. From the historical graph below it is clear that SCANA Corp. historically commanded a P/E ratio between 14 and 15 times earnings. SCANA Corp.’s low volatility (beta) is also vividly expressed graphically. It is also evident that SCANA Corp.’s earnings growth rate has been relatively flat, increasing at an average of only 3.4% per annum. But notice how stock price has closely tracked and highly correlated to this earnings growth rate.
When SCANA Corp.’s performance is calculated over this time frame, we learn that capital appreciation (closing annualized ROR) of 3.9% closely approximates historical earnings growth of 3.4%. SCANA Corp.’s record of dividend payments has been reasonably consistent with only two cuts since 1995. On the other hand, growth yield (yield on cost) has also been relatively slow and reasonably consistent with earnings growth.
The following 11-year historical graph on SCANA Corp. is offered to provide additional perspective. A quick glance at the bottom of the graph shows each year’s EPS, and just under that, the rate of change of earnings growth between each year that SCANA Corp. has historically achieved.
The significance of the following Estimated Earnings and Return Calculator lies in the fact that the consensus of 13 analysts reporting to Capital IQ, expect more of the same going forward for SCANA Corp.’s earnings growth. Perhaps there is a modest amount of optimism built into the 4.5% forecast; however, this estimate does not deviate much from the historical norm.
The following EYE (earnings yield estimates) table provides validation that SCANA Corp. currently trades at a fair valuation. The initial earnings yield of 7.1% is significantly greater than the current yield of 2.03% offered on a 10-year Treasury. Also, today’s current yield of 4.5% is also more than double the 10-year Treasury bond. Therefore, notice that all three dividend columns are shaded blue, indicating the initial yield greater than the Treasury bond, and that all columns pertaining to earnings are shaded green, which also indicates that earnings yield, is greater than the interest offered on the Treasury. The blue shading and green shading are consistent with the colors representing dividends and earnings on the historical F.A.S.T. Graphs™. This provides an instant visual that SCANA Corp. is attractively valued based on earnings yield and dividend rate.
Also, notice that SCANA Corp. does offer investors an attractive high single-digit long-term rate of return in spite of its low expected growth rate. Of course, this is attributed to the combination of moderate capital appreciation plus a moderately increasing growth yield (yield on cost). The reader should also note that the first years (2011) annualized rate of return of 93.5% is due to the fact that there are less than two months left in the year. In other words, if the stock were to rise to its fair value of $45.60, that would represent a high annualized yield over a very short time. The reader should also note that the expected annualized rate of return actually decreases in each successive year as future returns will revert to fair value based on an average growth rate of 4.5% plus a dividend yield growing at the same rate. To clarify this point, once SCANA Corp.’s P/E ratio expands from its current 14.1 to its fair value P/E of 15, the arbitrage from P/E expansion is expected to abate.
Our next example, Darden Restaurants Inc. (NYSE:DRI) is the world’s largest full-service restaurant company. The Darden family of restaurants features some of the most recognizable and successful full service dining restaurants to include: Red Lobster, Olive Garden, LongHorn Steakhouse, Capital Grille, Bahama Breeze and Seasons 52. Darden Restaurants Inc. (NYSE:DRI) can be bought at a similar price earnings ratio to SCANA Corp. and offers a competitive dividend yield.
However, what separates Darden Restaurants Inc. is a significantly higher level of past, present and future earnings growth. Therefore, even though the same current valuation is appropriately applied to Darden Restaurants Inc., the future return expectations are significantly higher due to the expected future growth rate that is almost triple that of SCANA Corp.
From the graph below we see that Darden Restaurants Inc. has consistently grown earnings at the average rate of 13.4% since calendar year 1995 its first year as a public company. Most importantly, Darden Restaurants Inc.’s stock price has closely tracked and correlated to their earnings growth.
When the associated performance results are calculated since 1995, we discover that Darden Restaurants Inc. has morphed from primarily a growth stock in the beginning, into an attractive dividend growth stock since calendar year 2005. Note how the dividend quadrupled in 2005 and how the payout ratio expanded. The effect this had on growth yield (yield on cost) is extraordinary.
As we did with SCANA Corp., the following 11-year historical graph on Darden Restaurants is offered to provide additional perspective. A quick glance at the bottom of the graph shows each year’s EPS, and just under that, the rate of change of earnings growth between each year that Darden Restaurants has historically achieved. The most important perspective the following graph provides is that Darden Restaurants has continued to average over 12% earnings growth even considering some short-term slowing during the great recession of 2008.
The consensus five-year estimated earnings growth of 12.5% by 29 analysts reporting to Capital IQ is consistent with Darden Restaurants’ historical achievement. It is this potential high level of growth that separates Darden Restaurants’ future total return potential from that of SCANA Corp.’s. Notice how the estimated earnings of $6.89 by fiscal year 2016 (Darden Restaurants has a fiscal year ending May 31 of each year) is much greater than the $3.79 expected for SCANA Corp.’s calendar year 2016. This expresses the principle of buying future earnings cheaper, even though the current P/E ratio of both companies is similar today.
The earnings yield estimates table below (EYE) tells the story of why Darden Restaurants is a cheaper stock than SCANA Corp. today, even though their P/E ratios and current dividend yields are similar. Darden Restaurants offers investors an earnings yield of 8% that should double approximately every six years thanks to the power of compounding (Rule of 72: divide 12.5% earnings growth into 72 = 5.76 years to double). Therefore, Darden Restaurants offers investors the potential “Holy Grail” of investing.
First, the opportunity for capital appreciation is high, assuming the earnings forecasts are met, because future earnings would be so much greater. In the same vein, the dividend growth yield (yield on cost) should double every six years consistent with the growth of earnings. Therefore, investors stand to achieve above-average capital appreciation in conjunction with an above-average and annually increasing stream of dividend income. Also notice that the total cumulative estimated dividend column shows that Darden Restaurants Group generates more total dividends than SCANA Corp.
The P/E ratio is a valuable investing metric that can significantly assist investors in making sound and profitable long-term investment decisions. However, for that to happen, the P/E ratio must be clearly understood and properly utilized in the decision-making process. At its core, it represents a great way to measure the true cost of the investment being considered, and simultaneously, the amount of risk being taken.
On the other hand, looking at the P/E ratio in a vacuum, and seeing it as a mere number is virtually worthless. A higher P/E ratio does not necessary mean a more expensive stock. If its growth rate is higher than a company with a lower P/E ratio, the potential investor can be buying future earnings cheaper than he would be by investing in the company with a lower P/E ratio and a lower growth rate, and vice versa.
Investor returns will always be a function of not just the price, but more importantly the valuations that apply when they are buying, selling or holding common stocks. In the long run, investor returns will correlate to, and be functionally related to the rate of change of earnings growth on the stocks they own in conjunction with the valuation they pay to buy them, and the valuation that the market is applying when they are sold.
Disclosure: Long SCG at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment adviser as to the suitability of such investments for his specific situation.
About the author:
Prior to forming his own investment firm, he was a partner in a 30-year-old established registered investment advisory in Tampa, Florida. Chuck holds a Bachelor of Science in economics and finance from the University of Tampa. He is a sought-after public speaker who is very passionate about spreading the critical message of prudence in money management. Chuck is a veteran of the Vietnam War and was awarded both the Bronze Star and the Vietnam Honor Medal.