Never pay more than twice the growth rate (converted to P/E) for a stock.
Most institutional investors, (the big guys behind the oak desks that move the markets) have a rule not to pay twice the growth rate for a stock…it is too expensive.
To determine the growth rate, we use FUTURE Earnings Per Share (EPS) estimates. Stocks trade six, nine, even sometimes twelve to eighteen months in the future and if you use the current or the past EPS numbers, most stocks will look overvalued when they could be actually quite cheap and you may miss the opportunity.
The company: Vandalay Industries (NYSE: GLC) trades at a P/E of 100 has the following EPS over the last few years:
These numbers show that from 2012 to 2013, GLC had 20% EPS Growth. A pretty respectable rate for the Latex Sales biz. With this rule, we would then expect to pay no more than a P/E of 40. [20% * 2 = Max P/E (Multiple)]. However, from 2013 to 2014, the growth rate slowed to 14.3%, which should cause a contraction to the multiple if we compared it to the year prior. We would now expect to pay no more than a P/E of 28.
Obviously we should sell it if we have it, or not even buy it (maybe even short it?) because it’s over valued. Right?
Wrong. We looked at the future predictions for EPS based on the management numbers and we noted the incredible demand for latex in several industry journals. The predicted EPS from 2014 to 2015 is 2.10, a 50% growth rate from 2014 to 2015 and the if the outlying years are even better, a P/E of 100 is not out of the question and maybe a reasonable valuation.
1) Expect to pay a higher multiple (than the peers) for the best-of-breed stock. The top dog in the business deserves a bit more…you pay for quality.
2) Expect to pay a higher multiple if the company consistently beats and raises earnings estimates at the quarterly conference call. We like managers that under promise but over deliver.