Valuation IV. Growth.

So now we have the basics. You know why valuation is so hard, and so valuable, too. Those pesky divergences make it extremely sensitive to the growth rate, the discount rate and the TIME the growth persists. You have to cut off the growth at some point or you get a divergence for any rational discount rate or for the growth rates of common growth stocks.

BUT that long winded tome-like post yesterday did give us a valuable baseline PE: namely, a 20x PE is reasonable in today's market for a company growing steadily at the GDP's nominal long-term growth rate of 5%. [NB: use only nominal discount rates to discount nominal growth. Use real discount rates to discount real growth. You MUST be consistent or will make a huge error.]

So, when we cut-off the growth at 3, 5 or 7 years, we can use a PE of 20x to value the future earnings stream to infinity. And for a medium quality credit, I think a discount rate for earnings of 10% is a reasonable midpoint. That's today's Treasury rate plus 5%. And over 70+ years, the long-term equity rate of return is around 8-10% depending on the time period.

So I constructed a spreadsheet present value model using these numbers. I used an earnings growth rate of 10%, a final market PE of 20x for a slow grower, and a discount rate of 10%. [NB: my PE is a ratio of current price to earnings for the next year.] To keep it simple, I did it annually. The answer was 26x for five years of growth before slowing.

I actually did a matrix, using 8%, 10% and 12% discount rates and 3, 5 and 7 years of growth. The valuations ranges from about 23x for 12% discount rate and 3 years growth to 31x for 8% discount rate and 7 years growth.

So you can see how the market valuation of companies can vary as the perception of future economic growth changes and the level of interest rates change.

So what? Well, PG certainly has a growth rate of at least 10% for many years in the past and recently. It's current PE is only 21x off 2007 earnings. Du'h ->> it should be at a PE of 24 to 33x. The US stock market is massively undervalued, IIFFF my economic outlook is correct.

And for the last year, I have been correct in my expectations of how the US economy would evolve. So until some news causes me to re-assess, I'm sticking to "LONG & STRONG"