P/E Ratios Important? (Drip Port) February 8, 1999

<THE DRIP PORTFOLIO>
P/E Ratios Important?
If so, how important are they?

by George Runkle ([email protected])

Atlanta, GA (Feb. 8, 1999) -- One of the more interesting questions about investing in stocks is about P/Es. How important is the Price/Earnings Ratio 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 don't matter." I've had others insist that any stock with a P/E over 15 is "overvalued" and should not be bought. Where is the truth? What is more important is how we need to look at P/Es as Drip investors.

This is the topic of today's Drip Port column. Tomorrow, Brian will continue with the portfolio's study of oil and gas leaders. So, kick back and today we'll talk "P/E."

First, let's dig out our handy spreadsheet and see how the P/E would affect us with an investment like Coca-Cola (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 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 Coca-Cola stock to be its Present Value for a given period of investment horizon and desired return. What is the desired return? There is a Capital Asset Pricing Model (CAPM) that determines this, and it involves the risk free rate of return (usually the return of the 30-year bond), the return of the market, and the beta of the stock. This gets the model a bit more complex, and involves a lot of assumptions anyway. So I'll just assume we want a long-term return of 11%, which is the historical market return. Let's assume Coke's earnings grow at 15% for our period of concern, which may or may not be too optimistic -- I'm using analysts' numbers for this. I will assume dividends will increase 1% a year.

The $64,000 question is what will Coke be worth at the end of our period? Will it still carry it's high P/E, or will it go to something much lower. Today, almost all good companies sport very high P/Es due to the low inflation/low interest rate environment we have. Nobody really can predict where the economy will be in five years. So, let's take Coke's Present Value in five years using several possible future Price/Earnings ratios:

P/E     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 ten years with the same assumptions:

P/E     Present Value
20          47.73
25          57.27
30          66.81
35          76.35

Whether Coke can sustain 15% earnings growth for 10 years is debatable, but if it does, it 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, even at its lofty levels, Coke is not such a bad buy. Now, as Drip investors, we tend to be invested in Rule Maker type stocks, which will carry a high P/E. Obviously, they could be subject to price corrections, and some time in the future they may not carry such high P/Es. However, the longer our expected holding period, the less important this is. That means we can pay more for a stock today and still get a reasonable return.

Drip investing puts us into some rather pricey stocks, like Coca-Cola and Johnson & Johnson. Since by its nature, investing in Drips is very long term, we don't really need to worry so much about the present P/Es. Also, the dollar cost averaging will help us in price dips. However, that will be the subject of another column. If you'd like to discuss this, please visit the Drip message boards linked at the top right of this page.

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