When someone says that the stock market looks expensive, often what he is saying is this: the current earnings yield that you are receiving is quite low. Of course, the total returns that you receive from an investment consist of two dominating variables: the earnings yield that you receive today, and the future growth rate that the company offers you thereafter.

The general concern right now is that companies that typically give you an initial earnings yield of 5-7% are currently giving you an earnings yield of 3-4% instead. Take something like Hershey chocolate. An absolutely excellent company, the kind of stock that once you buy, you never sell—letting the growing dividends that you receive every three months do the talking. Since becoming a large-cap chocolate manufacturer, Hershey’s fair stock valuation is usually when its stock trades at $20 for every dollar in profit that it makes, for a P/E ratio of 20 or an earnings yield of 5% depending on how you look at it.

Right now, Hershey is trading at about $98 and is making $3.66 per share in net profit. In other words, the earnings yield you are getting right now is 3.73% rather than the 5% that you might ordinarily expect. Unless you think that Hershey’s future prospects are brighter than usual, it would be wise to wait, as most calculations of fair value would put the objectively reasonable price of the stock somewhere in the $70s so that you could get a historically fair shake.

The only time it makes sense to be loose in accepting a low current earnings yield is when, with a high degree of certainty, you expect a company to have a high future earnings per share rate going forward. Visa is probably the best example of such a company.

Right now, Visa is making $8.45 in profit per share while trading at $212 per share. That gives you a 3.94% earnings yield plus whatever the future growth of the company happens to be. At first, that doesn’t sound all that different from Hershey, until you adjust for the fact that the future earnings per share growth rate of Visa is much higher than what you can get from Hershey.

In the case of Visa, you have a company that is growing earnings per share at about 8% annually in the United States, and 12-16% internationally (the wide fluctuation there is that estimates are imprecise, and they also must reflect currency fluctuations). Between 2008 and 2015, it looks like Visa will quadruple its profits. The company is unique because it has no debt, no pension, no preferred stock, and low capital investments that lead to large growth. Oh, and they are also funding a stock buyback program from their cash on hand, which adds another percentage point or three to the annual returns that investors experience. Visa’s earnings growth rate is a high-speed rail taking you to a place of higher underlying profits quickly. Heck, even from 2008 to 2009, during the financial crisis for heaven’s sake, the company managed to grow profits per share from $2.25 to $2.92.

This is why investing is an art rather than a science. Financial calculators can’t just spit out a list of good investments (with the exception of stuff like the Graham era portfolios that had a collection of stocks with 20% earnings yields that were widely diversified so that the survival of the many created such lucrative returns that it offset the failure of a few). Your ability to think is the most important part of the equation. When you find companies growing at a rate greater than 13%, and you conclude that there is a high likelihood of that growth continuing, a high valuation does not become a drag until you start paying over 35-40x earnings or so. Five years from now, there is a fair chance that Visa could be making $14-$15 per share in net profits. If you get the company and the growth rate, it doesn’t make sense to quibble over the valuation. You’d be looking back at today’s price in the low $200s wishing you would have chosen to strike when the fat pitch was crossing the plate.

Originally posted 2014-05-30 16:19:20.

Like this general content? Join The Conservative Income Investor on Patreon for discussion of specific stocks!