Equity Valuation and Portfolio Management

TWO-PHASE P/E ORBITS

The examples of constant growth rates in Exhibit 3.6 illustrate the natural path of P/Es when the market provides the equilibrium 9% return and earnings growth and dividend yield are constant. To achieve “sensible” orbits, growth rates must undergo at least one future shift that changes the orbit's basic direction. The simplest such shift in growth rates is a transition to a stabilizing rate that produces a horizontal orbit from the transition point forward. Such an orbit represents a going-forward version of the classic two-phase DDM, in which one growth rate holds prior to a defined horizon and then a second growth rate prevails in perpetuity.⁴

In the most common situation, the first phase has a higher growth rate than the final phase. In such cases, the starting fair-value P/E is always higher than the final P/E. The P/E descends along its orbit until the horizon point, where it should match the stable P/E of the final phase.

As an illustration, we revisit the earlier example (Exhibit 3.6) of a firm with a dividend yield of 1.6%, initial P/E of 25× and 12.4% earnings growth, leading to a P/E decline to 15× after 10 years. Instead of maintaining a single growth rate, we now assume that earnings growth slows in year 10 and the company enters a final phase of perpetual 7.4% growth. The upper curve in Exhibit 3.8 illustrates this P/E orbit, including the stabilizing growth rate that leaves the P/E unchanged at 15× for the remainder of time. The two growth rates ...