Posted By Jeff Traeger on 01/04/2012 10:11 PM
If I recall correctly, you said during the last webinar that you turn off "Enable Projected Average Return" in the preference section. I believe you went on to say that it is not favored by IAS nor yourself.
Assuming I have remembered this correctly, could you explain the "why" during the next webinar or here at the forum.
I have always like PAR as a measure as I view it as a more conservative measure versus the high P/E used for generating the "Total Return". My feeling is that a stock's price is more likely to hover around the average PE than at the high PE and therefore the average projected return is a more more sustainable number.
Yes, that is correct. We don't use Projected Average Return in the stock studies presented in the Investor Advisory Service. The thinking on both sides of the debate for and against PAR goes something like this:
The point of the future high price selection on the SSG is to determine the maximum likely high price the stock will reach if it grows EPS according to your analysis. If you have selected a reasonable future high P/E Ratio and a reasonable EPS growth rate, then your future high price selection should be attainable, and thus the measure of the upside potential of the stock at the current price should be reasonable as well.
Projected Average Return is calculated by using the share price determined by multiplying the company's projected EPS in five years by the average of your future high and low P/E Ratios. Those who like to look at Projected Average Return take the position that it's more likely that the stock will be selling near its average valuation in five years than at the very high end of the valuation range you establish (or, as you say, "a stock's price is more likely to hover around the average P/E than at the high P/E"). In addition, if the market is in a bear rather than bull cycle in five years, then the valuations of all stocks might be on the lower end of their historical ranges. Thus adherents of PAR see it as a more reasonable measure.
Those who prefer not to use PAR counter that if you look at the price and valuation histories of the typical stock, in any 52-week period prices do vary considerably (the average price of a stock on the NY Stock Exchange is said to vary 50% in a year), so you likely will have the opportunity to take advantage of the upside potential at any rate, and that's what you should be measuring with your study -- the upside potential, not the average potential. If you are conservative in your choice of growth rates and P/E Ratios, then this upside potential doesn't need to be adjusted downward any further. The future high price that you calculate on the SSG is not a "blue sky" figure, but a realistic target that the stock can reach.
There are nuances in the application of your judgment that come to play in deciding whether you want to consider PAR. If you are very conservative in your selection of future P/E Ratios and EPS growth expectations, then PAR becomes less meaningful and can be a bit warped, providing you with less meaningful information about a stock's possible future performance.