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Subject:  Re: Reward-Risk Analysis Date:  1/23/2008  10:30 PM
Author:  hheiserman Number:  1420 of 1817

Pedro -

Not naive at all.

First, my growth estimates. Management and analysts have used 14%. I think this number is high, given that retail stinks and the Martin + Osa concept isn't working (yet).

So I dialed back the growth forecast to 10% a year for the next five years, with a 50% decline beginning in year 6. Beginning in year 11, I assume 3% growth, which matches what the government says our inflation rate is (not that I believe them...the real number is closer to 10%, according to people who study this subject).

I hope AEO grows faster than these rates, but I'd rather err on the conservative side. Read David Dreman to learn how bad analysts are at forecasting, even going out just 6 months.

Second, the cost of equity. This is the return you need in order to get up off the sofa and call your broker to buy a firm's stock. (This return isn't guaranteed, of course.) My default rate is the yield of the 10-year treasury plus 500 basis points, or a minimum of 10%. The higher your cost of equity, the lower a firm's intrinsic value, and vice versa.

Speaking of Treasury yields, have you noticed how expensive the bond market is these days? The p/e ratio for the 3-month T bill is 46x, the 2-year sells for 49x earnings, and the benchmark 10-year has a p/e of 29x.

(A bond's p/e ratio is just the reciprocal of its yield. With the 2-year, its yield earlier today was 2.04%. So 1/.0204 = 49. By calculating the p/e ratios for bonds, you get a sense of whether stocks--which compete with bonds for investors' capital--offer good value or not. With the S&P 500 selling at 16x-17x earnings a few days ago, stocks give more bang for the buck than bonds.)

Folks are piling into Treasuries because they think lending money to the U.S. government is safer than owning stocks. Would you lend money to Washington? At these yields? Big mistake to own government bonds, I believe.

If I didn't fully explain anything, please let me know.

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