Future Growth – Producer of Stock Market Returns

Tuesday, December 1, 2009

1239215_graph_1Yesterday we looked at recent improvements in 2010 earnings projections for the Dow Jones Industrial Average’s (DJIA’s) 30 companies. Today, we will examine long-term growth forecasts along with the pricing for each stock.

The estimates of 2010 earnings are a combination of company growth along with recovery from economic slowdown and financial turmoil. Looking further out, we can focus on anticipated growth rates associated with a normal economy and fully functioning financial markets.

The table below shows analysts’ average 5-year earnings per share (EPS) projected growth rates for each DJIA company. Also shown are the price/earnings (P/E) ratios based on 2010 EPS forecasts. As we would expect, higher expected growth tends to carry a higher price.  The final column is a commonly used short cut measure, the PEG ratio = the P/E ratio divided by the long-term growth rate (G). (The higher the PEG, the more investors are willing to pay per unit of growth. For example, a P/E of 10 for 5% growth has a PEG of 2.0, which is higher than the 1.5 from a P/E of 15 for 10% growth.)

DJIA LT gr and PE

Clearly, there isn’t a precise PEG ratio that can be applied to all stocks. That’s because there are other variables that come into play, such as the growth uncertainty, dividend yield and financial soundness. But the link between long-term growth and the P/E ratio can be seen. I highlighted three relatively stable growth companies to show how different growth rates and P/E ratios can have similar PEG ratios: 3M, McDonalds and Chevron.

Note the two extreme companies, in terms of projected growth, to get a taste of the dynamics. At the top is Caterpillar, which could be a major beneficiary of infrastructure development worldwide. That heady growth rate projection reflects the potential as well as how management has structured the company to capture and profit from it. At the bottom is Pfizer, a past earnings powerhouse about to see key drugs like Lipitor come off patent. It is pursuing plans to try to increase the low future earnings growth projection, but analysts do not see the potential yet.

Now notice how the P/E ratio can mislead. Caterpillar, a company involved in the volatile construction industry, has an “expensive” 21.4. Pfizer, an established drug company, has a “cheap” 8.1. The PEG ratios tell a more accurate story: Caterpillar at 0.71 looks like a bargain and Pfizer at 4.04 looks overpriced. (*)

So, looking beyond 2010, we see good growth projections. These prospects form the basis for the current valuations and can be the source of future stock returns.

(*) Note: The stocks mentioned are examples only and should not be considered recommendations.

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John Tobey on Seeking Alpha

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December 2009