Given my excitement about Visa’s fall in stock price yesterday, I wanted to walk through my viewpoint of why I considered $60 to be a fair value for the stock but consider a $70 price based on current earnings estimates to be somewhat outside the zone of reasonableness that I would prefer to pay for the stock.
First, I should mention that I use the most recent quarterly earnings figure as my threshold point when valuing this stock. This is different from how I value most non-cyclicals like Johnson & Johnson, Coca-Cola, and Colgate-Palmolive. With the latter three companies, and many of the other companies that comprise the Dividend Aristocrat universe, I prefer to use the trailing twelve-month earnings figures because this is what Benjamin Graham preferred as it naturally carries a certain conservatism with it. You’re not going to go wrong buying Hershey, Brown Forman, and Nike at 19x trailing twelve months earnings, unless Treasury rates were over 9% or something truly outside the bounds of normal economic activity was going on.
But with the truly superior growth companies, I prefer to rebase my earnings calculations based on the most recent quarterly earnings reports because the extra conservatism is not warranted. In the case of Visa, the company has grown earnings from $0.56 per share in 2008 to an estimated $2.65 per share this year. Profits have almost quintupled in seven years. When earnings are advancing at such a prodigious clip, you have to acknowledge that somewhere in your valuation of the stock.
That is why, when Visa reports earnings, I use the recent $0.74 per share in profits as the base in calculation the P/E ratio rather than calculating what Visa actually earned over the previous twelve months. In other words, I gauge Visa’s earnings power as $2.96 rather than the $2.52 that it actually earned during the second half of 2014 and the first half of 2015 that would comprise the trailing twelve months of earnings.
When Visa’s stock came down to $60 per share yesterday, it caught my attention because the P/E valuation would be 60/2.96=20.2x earnings based on how I would prefer to figure out a suitable valuation for a company of Visa’s caliber. Graham advised against getting in the habit of paying more than 20x earnings for large-cap stocks, as prices above 20x earnings tend to incorporate a negative margin of safety that will deliver total returns that are lower than the actual earnings per share growth of the company in question.
That is about the high end of fair value that I would want to buy for a company. Considering that I believe Visa has the best earnings per share growth characteristics out of any company within the Dow Jones, and possibly the S&P 500, I wouldn’t split hairs about the distinction between 20x earnings and 20.2x earnings. The important thing is staying from 30x earnings territory for the initial purchase price, as there will inevitably be 33% P/E compression that will take a bit out of the earnings growth that you experience.
Now that Visa has quickly recovered from yesterday’s flight towards fair value, the $70 price tag pushes the stock towards 24x earnings. That’s the No Man’s Land territory for Visa’s stock valuation. It is not nearly enough to consider selling, which is probably something you shouldn’t think about until you start seeing Visa’s valuation eclipse 35x earnings.
Nor is it a valuation where you can clearly say “Be Patient and Don’t Buy It Now”, like you could if Visa traded in the neighborhood of 30x earnings. Instead, it sits there right above fair by about 15% or so: If someone were to pay $70, I’d doubt they would regret it 15+ years from now. On the other hand, opportunities have existed in four out of the past six years to purchase the stock at 20x earnings or below, so patience seems warranted based on the stock’s trading history.
In short, Visa at $60 provided clarity that the stock was trading darn near fair value that you can’t say with the stock at $70 a day later. Absent more days like yesterday, it looks like it is back to focusing on energy stocks (Chevron, Exxon, BHP, Conoco, BP, and Shell) and companies that are tangentially related to the energy sector (Emerson Electric, General Electric). And then there is the class of companies, like Wal-Mart and IBM, that trade at discounts as they work through their own growth hiccups.
A quick look at morning trading indicated that most stocks are moving up by a decent amount again. That’s not fun for me. It’s a lot easier being a finance writer when everything is going down by a lot because then all I have to do is point out the best high-quality growth companies and my job is done. You don’t have to worry about valuation in years like 2008 and 2009–everything is cheap. But when the markets are trading near all-time highs, like we still have now, the game is tougher because I have to find companies with blemishes that have caused the price of the stock to get beaten down more than warranted.
I’d love to see Visa continue to grow by 12-15% and the stock fall to the $50s. It wouldn’t take a nuclear engineer to figure out what is smart to do. You wouldn’t even need me anymore. I could let out a Visa grunt and you could take care of the rest.