Valuing growth stocks by their payback
How the payback works
A P/E of 20 means you pay $20 for every $1 the company earned over the last year. Read another way: if its earnings never changed, the company would take 20 years to earn the $20 you paid for its share. That's the P/E read as a payback period.
Earnings do change, though. The calculator grows them each year at the rates you set and adds them up until they reach the price; the year they get there is the payback. A company on a P/E of 20 whose earnings grow 15% a year for five years, 8% for the next five and 3% after that earns back its price in about 9.8 years, not 20.
Why not just the P/E?
The P/E counts only the last twelve months' earnings, so it says nothing about where they're going, and one unusually good or bad quarter can swing it. The forward P/E looks a year ahead instead, but no further, and it swings the same way. The payback asks what the P/E leaves out: how fast earnings will grow, and for how long.
Why not the PEG ratio?
The PEG divides the P/E by the growth rate, usually the next five years'. Take two stocks with the same PEG of 2: one on a P/E of 10 growing 5% a year, the other on a P/E of 30 growing 15%. If neither grows after five years, the first earns back its price in about 8.3 years and the second in about 16.1, twice as long. The PEG can't tell them apart.
A high P/E isn't always expensive
A P/E of 50 looks expensive. But if the company's earnings grow 30.5% a year for five years and 7.5% for the next five, then stop growing, it earns back its price in about 12.7 years: sooner than a company on a P/E of 15 whose earnings stand still, which takes 15.
Counting later earnings for less
A dollar earned fifteen years from now is worth less than one earned today: today's could be invested in the meantime, and the future is less certain. The discount rate counts each year's earnings for less the further out they are. At 8% a year, the first example above takes about 16.1 years instead of 9.8, and the P/E of 50 about 39 instead of 12.7: the more a payback leans on earnings far ahead, the more discounting stretches it.
What it can't tell you
- It's only as good as your growth guesses. For a high P/E, small changes in the later years move the payback by years.
- It counts earnings, not the cash paid out to shareholders, and a company's debt and cash don't come into it.
- A company losing money has no P/E, so no payback on its earnings.
- One-off gains or charges in the last twelve months' earnings carry into every year after.
It works best for comparing stocks on assumptions you believe, side by side, rather than as a price target. Compare Stocks puts their P/E and growth next to each other.
Formerly the implied P/E
This calculator used to be called the Implied P/E Ratio Calculator. Elsewhere, “implied P/E” usually means the P/E a price target or a valuation model points to, so it's now named for what it measures: the years to earn back the price.