Quality of earnings and time in the market are probably the two most important criteria for successful investing and wealth creation. Companies with sustainable, high-quality earnings – the long-term compounders we all covet for our portfolios – include those with durable moats, pricing power, and which are addressing large and growing markets. Often, however, we as individual investors identify one of these long-term “multi-baggers” well after the stock has been “discovered” by the market. We are dismayed by a share price reflecting the market’s high expectations and find it difficult to “pull the trigger” at a price-earnings ratio (PE) of 30 or 40 or more, when average (long-term) multiples are much lower, for fear of buying at a peak and then witnessing only marginal returns or even a (paper) loss that could occur simply because of a contraction in overall PE multiples. So, to paraphrase Warren Buffett, we “thumb suck”, we wait, paralyzed, for a better entry point that may never come. Perhaps, we seek out a “value play” instead, a stock selling at a depressed multiple that we believe will go on to achieve outperformance in earnings growth that causes the market to rerate the stock at a higher multiple and thus, reward us with a stellar return. Beware “thumb-sucking”. Beware “value plays” that may be “value traps”.
If we are prepared to remain invested in best-in-class companies, with the qualities mentioned above, and run by excellent managers, for 5, 10, or even 20 years, then “high” entry PE multiples are not necessarily an impediment to achieving satisfactory returns. Table 1 below depicts, for a 5-year holding period, the compound annual growth rates (CAGRs) for investments in 8 hypothetical companies and the S&P 500, each with a different earnings per share (EPS) growth rate, purchased at various entry price/earnings (PE) multiples, and sold at either: (1) the long-term market average PE multiple, 20 in this case (rounded up)[1], for EPS growers at or above the S&P 500’s historical level, or (2) a hypothetical multiple of 10 for substandard EPS growth (5%, 0%, -5%). For the sake of clarity, CAGRs that round to 10% or better are highlighted in bold. The results indicate that, e.g., even a 45 PE purchase can produce double-digit results should market multiples contract to the long-term average, if the underlying earnings growth is 30%.[2]
The next two tables show the results for the longer holding periods of 10 and 20 years. What becomes apparent, upon inspection, is that longer investment horizons are more “forgiving” as to high entry PE multiples. For a given EPS growth rate, the longer the horizon, the higher the entry PE ratios that can still result in returns that are not just positive, but double digits. (Note that when entry multiples are lower than exit multiples, returns decline toward the EPS growth rates with increasing time. Conversely, higher entry than exit multiples lead to returns that rise toward the EPS growth rates with increasing time.) However, not all outcomes bring joy. A “value play”, bought even at a below-average 15 times earnings, but whose growth proves disappointing, might easily result in marginal or negative returns, as the market refuses to reward it with even an average multiple. (See the 5%, 0%, and -5% cases in the tables. Of course, some “value plays” prove to be winners whose EPS growth surprises the market, but not you, the astute individual investor who discovered them early!)
Superior businesses, with sustainable and high-quality earnings, justifiably receive greater attention and higher PE multiples from the market. Those growing earnings, combined with a long investment time horizon, outweigh even a market PE contraction to produce satisfactory or superior long-term investment results. While it is not easy to uncover those businesses that will continue to realize above-market growth over medium to long periods of time, one should feel that “pulling the trigger”, at least for a starting position, may be just fine, when they are personally convinced of having found one, even if the market has apparently already recognized it. It could break the “thumb sucking” habit and bring joy to one’s financial life.
Table 1. 5-year Compounded Annual Growth Rates (CAGRs) of equity investments at given PE multiples upon purchase, given earnings per share (EPS) growth of the underlying businesses, and exit PE multiple at the long-term market average, except for EPS underperformers (5%, 0%, -5%)
Compound Annual Growth Rate (CAGR) of Investment
| 5 years | Entry PE Multiple | |||||||
| EPS Growth Rate | 15 | 20 | 25 | 30 | 35 | 40 | 45 | Exit PE Multiple1 |
| 30% | 37.70% | 30.00% | 24.33% | 19.87% | 16.23% | 13.17% | 10.54% | 20 |
| 25% | 32.40% | 25.00% | 19.54% | 15.26% | 11.76% | 8.82% | 6.29% | 20 |
| 20% | 27.11% | 20.00% | 14.76% | 10.65% | 7.29% | 4.47% | 2.03% | 20 |
| 15% | 21.81% | 15.00% | 9.98% | 6.04% | 2.82% | 0.11% | -2.22% | 20 |
| 10% | 16.51% | 10.00% | 5.20% | 1.43% | -1.65% | -4.24% | -6.47% | 20 |
| S&P 8.25%[3] | 14.66% | 8.25% | 3.53% | -0.18% | -3.21% | -5.76% | -7.96% | 20 |
| 5% | -3.18% | -8.59% | -12.58% | -15.71% | -18.27% | -20.42% | -22.28% | 10 |
| 0% | -7.79% | -12.94% | -16.74% | -19.73% | -22.16% | -24.21% | -25.98% | 10 |
| -5% | -12.40% | -17.30% | -20.91% | -23.74% | -26.05% | -28.00% | -29.68% | 10 |
Table 2. 10-year Compounded Annual Growth Rates (CAGRs) of equity investments at given PE multiples upon purchase, given earnings per share (EPS) growth of the underlying businesses, and exit PE multiple at the long-term market average, except for EPS underperformers (5%, 0%, -5%)
Compound Annual Growth Rate (CAGR) of Investment
| 10 years | Entry PE Multiple | |||||||
| EPS Growth Rate | 15 | 20 | 25 | 30 | 35 | 40 | 45 | Exit PE Multiple1 |
| 30% | 33.79% | 30.00% | 27.13% | 24.83% | 22.92% | 21.29% | 19.87% | 20 |
| 25% | 28.65% | 25.00% | 22.24% | 20.03% | 18.20% | 16.63% | 15.26% | 20 |
| 20% | 23.50% | 20.00% | 17.35% | 15.23% | 13.47% | 11.96% | 10.65% | 20 |
| 15% | 18.36% | 15.00% | 12.46% | 10.43% | 8.74% | 7.30% | 6.04% | 20 |
| 10% | 13.21% | 10.00% | 7.57% | 5.63% | 4.01% | 2.63% | 1.43% | 20 |
| S&P 8.25%3 | 11.41% | 8.25% | 5.86% | 3.95% | 2.36% | 1.00% | -0.18% | 20 |
| 5% | 0.83% | -2.03% | -4.19% | -5.92% | -7.36% | -8.59% | -9.66% | 10 |
| 0% | -3.97% | -6.70% | -8.76% | -10.40% | -11.77% | -12.94% | -13.96% | 10 |
| -5% | -8.77% | -11.36% | -13.32% | -14.88% | -16.19% | -17.30% | -18.27% | 10 |
Table 3. 20-year Compounded Annual Growth Rates (CAGRs) of equity investments at given PE multiples upon purchase, given earnings per share (EPS) growth of the underlying businesses, and exit PE multiple at the long-term market average, except for EPS underperformers (5%, 0%, -5%)
Compound Annual Growth Rate (CAGR) of Investment
| 20 years | Entry PE Multiple | |||||||
| EPS Growth Rate | 15 | 20 | 25 | 30 | 35 | 40 | 45 | Exit PE Multiple1 |
| 30% | 31.88% | 30.00% | 28.56% | 27.39% | 26.41% | 25.57% | 24.83% | 20 |
| 25% | 26.81% | 25.00% | 23.61% | 22.49% | 21.55% | 20.74% | 20.03% | 20 |
| 20% | 21.74% | 20.00% | 18.67% | 17.59% | 16.69% | 15.91% | 15.23% | 20 |
| 15% | 16.67% | 15.00% | 13.72% | 12.69% | 11.83% | 11.08% | 10.43% | 20 |
| 10% | 11.59% | 10.00% | 8.78% | 7.79% | 6.96% | 6.25% | 5.63% | 20 |
| S&P 8.25%3 | 9.82% | 8.25% | 7.05% | 6.08% | 5.26% | 4.56% | 3.95% | 20 |
| 5% | 2.89% | 1.42% | 0.30% | -0.61% | -1.38% | -2.03% | -2.61% | 10 |
| 0% | -2.01% | -3.41% | -4.48% | -5.34% | -6.07% | -6.70% | -7.24% | 10 |
| -5% | -6.91% | -8.24% | -9.25% | -10.08% | -10.77% | -11.36% | -11.88% | 10 |
[1] https://www.macrotrends.net/2577/sp-500-pe-ratio-price-to-earnings-chart (70-year average)
[2] A simple screen on Fidelity.com for 30%+ EPS growth over the last 5 years produced 564 stocks. Of course, past performance is no guarantee of future performance. One needs to do their own research and draw their own conclusions.
[3] https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/spearn.htm (1961-2023)