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The common rule of thumb that you're probably all familiar with is known around here as the "Fool Ratio". Taken loosely, it says that a company's P/E ratio should be roughly equal to its projected annual growth rate. A P/E much lower than the growth rate means "Buy" and one much higher than the growth rate means "Sell". This "rule" is often very useful, but can cut the wrong way if you use it incorrectly.

This weekend, Barron's used the rule incorrectly.

The assertion was made than if Cisco is to be worth 190 times its earnings per share, its growth rate would have to be 190% annually. The article followed by showing that if Cisco really grew by 190% annually for 10 years, it would swallow the earth, so to speak. Clearly, since Cisco can't possibly grow that fact, the article continued, it shouldn't be worth 190 times earnings.

A good thought experiment is to imagine a fictitious company that really could increase earnings 190% a year for ten years. (Barron's mentioned 2010, so I'm using their same ten years). The question is: what would you pay as a P/E today for that company?

Is the answer "190"? That's what the rule says. Let's see if that's right.

Let's say that today, the stock's at $190 and the company is earning $1/year. After one more year, the company is earning $2.90. (A 190% increase). After 5 years, it's earning $205 per share. After 10 years, it's an insane $42,000 per share.

If the price then is, say, just 15 times earnings, then it's $42,000 x 15 = $630,000.

Your $190 grew to $630,000 in 10 years. Does that sound like a stock you'd be indifferent to? Of course not. Now, if the growth rate were 170%, or 150%, or 130%, do you think that your initial P/E of 190 was too high? (130% gives you $62,000 after 10 years).

Clearly, a P/E of 190 is not "about right" for a growth rate of 190%!

My way of thinking is different from Barrons'. I ask these questions:
1) What return am I looking for over those 10 years?
2) What will the price then need to be to provide that return?
3) What will the P/E ratio be then?
4) What must the earnings thus be, then?
5) Finally, what must the annual growth rate in earnings be to get earnings from today's to the right answer?

Take again the company with a price of $190 and earnings of $1.

1) Over ten years, I'd like a 15% return.
2) That's a final price of about $769.
3) The P/E will be 35. (GE's is 45 today).
4) The earnings must then be $769/35 = $22.
5) The earnings growth rate must thus be around 37%.

Get that? A 10-year annualized growth rate of 37% would give me a 15% return on a stock price that's currently 190 times [trailing] earnings. That's 37%, not 190%.

Now, what to make of this vis-a-vis Cisco, specifically? Well, "real-time" P/E (as opposed to the twelve trailing month P/E) appears to be a little over 100, not 190. That drops the required growth down below 30%.

This is all not to say that Barron's must be dead wrong in their belief that Cisco is overvalued. A 30%-ish growth rate, especially for 10 years, is indeed extremely high by most standards.

It's up to each of us to decide whether or not Cisco will grow as fast for as long, and with such a high final P/E, as the current P/E requires. It does requires some mighty impressive future performance.

But it does NOT require Cisco to grow at 190% annually to deserve today's P/E multiple. Not at all, and Barron's should have known better.

(Disclosure: long on CSCO, about 3% of my holdings)
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