Example to show why investors pay a high PE for growth stocks
This important principle creates the opposite of a modified internal rate of return. Thus, it creates an accelerated two-part rate of return for the investor. An example follows:
- Equity $100,000
- ROE 30%
- Investor pays $1,000,000 or a P/E of 33 and thus first year earnings return equals 3%.
However, the investors ROE does not remain at 3% even as we assume that the companies ROE remains at the above stated rate.
Why? The new reinvested earnings earn the companies ROE rate. Demonstrated as:
- First year -- $39,000/$1,030,000 equals 3.8%
- Second year -- $50,700/$1,069,000 equals 4.5%
- Third year -- $65,910/$1,119,700 equals 5.9%
- Fourth year $85,683/$1,185,610 equals 7.2%
- Fifth year $111,387/$1,271,293 equals 8.7%
- Sixth year $144,803/$1,382,680 equals 10.5%
- Seventh year$188,244/$1,527,483 equals 12.3%
- Eighth year $244,717/$1,715,727 equals 14.3%
- Ninth year $318,132/$1,960,444 equals 16.2%
- Tenth year $413,575/$2,278,576 equals 18.1%
Assuming the 30% ROE continues for ten years, the companies earnings will be $413,575.
Assuming the ROE now drops to 10% and the companyÃÂÃÂs earnings are paid out to the investor as a dividend, the investment would be worth $413,575 / .10 or ~ $4,100,000. The investorÃÂÃÂs IRR would equal ~15%.
If the residual earnings are capitalized at a 15 P/E the investors return equals ~18%. Using either scenario for the residual sale, the investor earned an above market rate of return.
In conclusion, the investorÃÂÃÂs success depends on the ROE of reinvested earnings. Of course, the companyÃÂÃÂs ROE depends on the their ability to create products, market those products, control costs, hire and keep competent management and employees and continue to successfully employ capital over the long term ÃÂÃÂ no small feat. In the end, an investor can pay a high P/E and still come out with an excess market rate of return if they pick a well managed firm with a high growth rate.
See also