In Hindsight, How Much Should You Have Paid for That Company?

I recently read this in the Financial Times, and I loved it:

The rating of the [Nifty Fifty] reached its peak in 1972, when shares in Coca-Cola and Xerox each cost 46 years' earnings. Over the following 25 years, the ratings fell to Earth, while the actual performance of the companies allowed Wharton School professor Jeremy Siegel to work out whether those eye-watering ratings had been justified. Some had turned out to be absolute dogs: Xerox's performance warranted a price/earnings ratio of 18 rather than 46. But Coca-Cola was so successful it would have been worth paying 92 times 1972 earnings.

That's a neat way to think about it. How much should you have been willing to pay for a company in hindsight to achieve an acceptable rate of return? Put differently, what P/E ratio could I have purchased a company for in the past and still earned an average rate of return through today?

I wondered how this logic would look if we applied it to today's Dow stocks. So here's that, using 1995 as a starting year and requiring an 8% annual return (including dividends): 

Sources: S&P Capital IQ, author's calculations, and an afternoon wasted in an Excel spreadsheet.

It's a huge range. UnitedHealth Group may have looked pricey at 28 times earnings in 1995, but you could have paid three times that amount and still earned an 8% annual return over the following 17 years. Bank of America (NYSE: BAC  ) may have looked cheap at seven times earnings, but it was worth only a fraction of that if you held through today.

This is merely a hindsight exercise, and doesn't really say what you should have done in 1995. No one could have known in 1995 that Bank of America would go hog wild during a mid-2000s housing boom and dilute its shareholders down to the ground in the aftermath. And no one could have known that McDonald's would successfully navigate a huge international expansion. Investing is about risks and unknowns, which have to be accounted for in current prices. The fact that we don't know what the future outcome will be is what allows stocks to earn higher long-term returns than bonds or cash.

But what strikes me about this table is how wide the range is. The average absolute value of the difference between the actual 1995 P/E ratio and the P/E ratio you could have rationally paid is 18.1 -- a huge number if you think about it.

To me, the takeaway is that over long periods, most companies will either be very successful or very disappointing, with less in between than most of us probably imagine.

What do you think?

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Read/Post Comments (12) | Recommend This Article (46)

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  • Report this Comment On January 16, 2013, at 12:07 AM, DrGoldin wrote:

    So much for the efficient market hypothesis!

  • Report this Comment On January 18, 2013, at 10:56 AM, CluckChicken wrote:

    For the most part my answer to "How Much Should You Have Paid for That Company?" is less.

  • Report this Comment On January 18, 2013, at 11:18 AM, Idahoave2013 wrote:

    Morgan is always so interesting. Love your stuff.

  • Report this Comment On January 18, 2013, at 1:33 PM, luxetlibertas wrote:

    There is a huge surviver bias in this kind of analysis, as interesting as it seems.

    If you want to say something about a hypothesis like "To me, the takeaway is that over long periods, most companies will either be very successful or very disappointing, with less in between than most of us probably imagine." then you'd have to take a stock collection and follow it over some interval, say 15, 20 or 50 years, in a Buy and Hold strategy. Date of purchase could be a fixed date or spread over time.

    Would be a lot of work of course, if you cannot tap into existing high-quality research data.

  • Report this Comment On January 18, 2013, at 2:18 PM, digitally404 wrote:

    That's why it's important to have a long-term mindset and invest for success!

  • Report this Comment On January 18, 2013, at 3:36 PM, philkek wrote:

    Good article makes you think. In 1995 I knew nothing about stocks. I invested in my company's 401k plan. That plan invested 100% in the SP500. Best investment I ever made.

    Companies here are among the SP500. Otherwise I'd not have invested in them.

    MF taught me basic fundamentals. One guy recently told me he gained about twice as much as SP500. He traded select stocks over same 10 year time period.

    He invested good individual companies. I used SP500 fund.

    MF writers fool on. Thanks for info about P/E risk vs reward possibilities. Challenging.

    Better Business Bureau advises; Investigate Before You invest.

  • Report this Comment On January 18, 2013, at 4:20 PM, seattle1115 wrote:

    The majority of those companies were relative bargains when evaluated in this manner. That reinforces my sense that buying a diverse portfolio of solid companies and holding it for a long time will cover a multitude of valuation errors.

  • Report this Comment On January 20, 2013, at 3:02 AM, daveandrae wrote:

    What do I think?

    After nearly fifteen looooong years of experience in this volatile business, personal observation has shown me that most people do not have patience, nor more importantly, the stomach, to hold ANY stock through all of its vicissitudes for seventeen years.

    Thus, at the end of one's lifetime, stock selection, and market price, the two variables most people put their overwhelming amount of energy into, will have accounted for very little, say, 5-10% tops, of "Investor Return."

    In this business, that which is most important, is whether or not your subsequent behavior is appropriate for the investments you have chosen.

    Put simply, the overwhelming variable that determines ultimate success, or failure, is also, the only variable you have ANY control over....your own behavior.

    Example- If one were to juxtapose Investor return against investment performance over the 1995-2012 period, I am quite certain one would find no correlation whatsoever. In fact, i would bet you dollars to doughnuts that the juxtaposition is quite horrifying.

    Thus, at the end of the day, It is not what your stocks do or don't do. In this business, It's what YOU do and don't do. Especially when, not if, those investments are down 35-50%, which one day they surely will be.

    Good Day

  • Report this Comment On January 20, 2013, at 12:55 PM, Tomohawk52 wrote:

    To me it shows that perhaps many people are much better off buying an index fund, and then totally ignoring it, rather than try to pick even a bucketful of blue chips.

  • Report this Comment On January 20, 2013, at 10:41 PM, shamapant wrote:

    Warren Buffett paid 42x aftertax earnings for Nebraska Furniture Mart. He knew the business really well and was extremely confident that it would grow predictably in the future(due to his confidence in the management team), so even at that price he thought it was cheap. He got a 23% compounded return on it over 10 years. So it's clearly not about price alone, it's price relative to the value(now and in the future), and that value is determined by the investor. Buffett was confident that the value in the future would be higher than the price he paid, and he was right. interesting case study.

  • Report this Comment On January 21, 2013, at 12:11 AM, sheldonross wrote:

    Curious, does this evaluation take into account dividends? If not the returns could be significantly better even.

  • Report this Comment On January 21, 2013, at 4:28 AM, KurtEng wrote:

    Hi Morgan,

    This is a nice data set so I looked into it a bit. The average 1995 p/e was 16.4 but the average 'hindsight p/e' is 33.1, which means that stocks were cheap in hindsight. I plotted the ratio of hindsight p/e to 1995 p/e against 1995 p/e and found very little correlation. In other words, buying low p/e stocks wouldn't have benefited investors at that exact time, but the results would be about the same as buying high growth stocks. All of the ratios below 1 (meaning the stock was overprices were for 1995 p/e below 12 but the two highest ratios were also from that group. I guess it just reinforces the power of growth and the need to diversify. One major point is that a dying or stagnant business is a bad deal at almost any price.

    Kurt

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