Calculating Fair Value With Growth

Our investing journey revolves around finding the fair value of a common stock. If you can find stocks that are cheaper than its fair value, it is probably a buy. If your stock holding rises way above your calculated fair value, it is most likely a sell. This fair value is not constant, fluctuating due to several factors from interest rate movement and to commodity prices. Previously, I stated that the fair value (selling price) of a stock is when its P/E hits .. This gives investors a yield of .%, which is % above the current yield of a year treasury bond. We use year treasury bond as our proxy for 'free risk' interest rate. Now, obviously, you have seen a lot more stocks valued at a P/E of more than ., some as high as . Are they overvalued? Not necessarily since my P/E calculation assume a % growth. As you may know, earnings does not stay constant all the time. Google did not exist a decade ago and it now rakes in billion of dollars of profit. So, how do we value company with a growing earning? Now, I don't normally assume growth when calculating fair value, but I am going to take a stab at it today. For now, let's make things really simple. We'll assume that EPS for the current year is $ . . Furthermore, earning growth will be % for the next years and then stay constant afterwards. I think this is a realistic assumption. Predicting earning growth beyond the years is like predicting who will be the next president years in advance. Now, our next step is to determine that constant EPS after years of growth. With EPS of $ ., years from now, EPS will come in at $ .. So, if we bring this back to the present, how much is this $ . worth? Please note that $ . now is more valuable than $ . five years from now. Using a .% discount rate, that $ . of future earning is worth $ . per share today. Therefore, in essence, the company will be earning $ . constantly with % growth. Using a P/E of ., the company has a fair value of $ .. At this price, the company is valued at . trailing P/E ratio. You can do similar exercise to other companies with higher growth rate. You'll find out that some of them are valued at a P/E of or more with the growth assumption built into it.