What is growth worth?

The number worked backwards

A P/E ratio is a price for the profit. If you assume the company pays out its whole profit every year, the same sum as in the lesson on discounted cash flow tells you what P/E a given growth adds up to. The table shows it for growth over ten years and 2% a year after that, at three required returns:

Two things stand out. Growth matters a lot: between 0 and 20% growth a year for ten years lies the gap between a P/E of 14.6 and 67.4. And the required return matters almost as much. At 10% growth the number is 38.6 at a 7% return and 26.5 at 9%. The further ahead the profit lies, the harder the required return hits, which is one reason fast-growing companies often fall the most when interest rates rise. More on that in the lesson on interest rates and the stock market.

What the price assumes

Turn the table around and you get the growth a price assumes. Among the 20 largest US companies the middle today is a P/E of 37.6, worked out on market cap and the latest fiscal year's profit. At an 8% required return that means roughly 12% profit growth a year for ten years. It is no answer key: the required return is a choice, the profit is one year's and few companies pay out all of it. But the sum turns a high or low P/E into a question you can test: is that growth reasonable for this company? How P/E differs between companies is in the lesson on P/E ratios.

Growth costs money

A growing company usually has to invest in factories, stock or buying other companies, and that takes from its cash flow. Growth only creates value when the investment earns more than the required return. A company that grows with money earning less than that gets bigger, but not more valuable.