

By
One of the more interesting questions about investing in stocks centers on the pricetoearnings ratio (P/E). How important is the P/E when deciding on a stock to buy? In chat rooms, I've run into extremes on both ends. I've had people insist that "valuations do not matter." I've had others insist that any stock with a P/E over 15 is overvalued and should not be bought. What is most important here is how we need to look at P/Es as Drip investors.
First, let's dig out our handy spreadsheet and see how the P/E would affect us with an investment like CocaCola (NYSE: KO). What I'm going to do is project earnings and dividends forward, and then take a present value. It's actually quite simple in concept, and easy to do with a spreadsheet. Let me explain the concept of "present value" first.
Let's say you wanted to have $1000 in five years. You expect to get a 10% return on your investment, so how much do you need to invest? If that interest is compounded yearly, you need to invest $620, which is the present value of $1000 five years from now at a 10% return.
So, we can consider the cost of CocaCola stock to be its present value for a given period and desired return. What is the desired return? There is a capital asset pricing model (CAPM) that determines this, and it involves the riskfree rate of return (usually the return of the 30year bond), the return of the market, and the beta of the stock. This makes the model a bit more complex, and involves a lot of assumptions. So, I'll just assume that we want a longterm return of 11%, which is the historical market return (even though Drip Port's goal is over 15%).
Now, let's assume that Coke's earnings grow at 15% for our period of concern, which may or may not be too optimistic. I will assume dividends will increase 1% a year.
The $64,000 question is what will Coke be worth at the end of our time period? Will it still carry its high P/E, or will the P/E be much lower. Today, almost all good companies sport very high P/Es due to the low inflation/low interest rate environment that we have. Nobody really can predict where the economy will be in five years. So, let's figure Coke's present value (it trades at $53 today) in five years using several possible future P/E ratios:
P/E 5Year Present Value 20 35.74 25 43.74 30 51.72 35 59.72
Obviously, Coke appears to be quite expensive today if we expect its future P/E to be 20. It's interesting to look at the present value of the stock if we expect a longer holding period. Let's look at Coke in 10 years with the same assumptions:
P/E 10Year Present Value 20 47.73 25 57.27 30 66.81 35 76.35Whether Coke can sustain 15% earnings growth for 10 years is debatable, but if it does, it almost certainly will merit a higher P/E than 20 in my opinion. My guess is it will sport a P/E of about 30 to 35. So, its lofty levels today may not look so lofty 10 years from now.
Now, as Drip investors, we tend to be invested in Rule Makertype stocks, which will carry a high P/E. (Only a few days remain to signup for the Rule Maker Seminar, by the way. It's $35.) Obviously, these kinds of companies could be subject to price corrections, and some time in the future they may not carry such high P/Es.
Drip investing puts us into some rather pricey stocks, like CocaCola and Johnson & Johnson. However, since by its nature investing in Drips is a very longterm, steady process, we don't need to worry as much about the present P/Es because dollar cost averaging will help us buy more during price dips. If you'd like to discuss this, please visit the Drip discussion boards linked below.