The Process
We use current
earnings estimates to calculate both a “payback period” and a
projected average annual return on a stock. The payback period is how
long it would take a projected earnings stream to add up to the stock
price.
An Example
At the beginning
of the 4th quarter of 2007, Rowan Drilling was expected to earn $4.09
per share in 2007 and $4.94 in 2008. Analysts thought that Rowan could
grow earnings at an average rate of 15% per year after 2008. The
following table shows projected earnings:
|
|
| Period |
Earnings |
Cumulative
Earnings |
| Year to Date 2007 |
$3.07 |
- |
| 4th Quarter 2007 |
$1.02 |
$1.02 |
| 2008 |
$4.94 |
$5.96 |
| 2009 |
$5.68 |
$11.64 |
| 2010 |
$6.53 |
$18.18 |
| 2011 |
$7.51 |
$25.69 |
| 2012 |
$8.64 |
$34.33 |
| 2013 |
$9.94 |
$44.27 |
|
|
| 2007 earnings: $4.09 total |
| < $3.07 already |
| < $1.02 future |
Stock Price at Time of Analysis
< $36.50 |
The analysis indicates that the then current stock
price of $36.50 is earned back by early 2013, or more precisely a payback
period of 5.47 years. To estimate a forward price, we assume a
price-earnings ratio equal to the projected earnings growth rate - in this
case 15. Multiplying 15 by estimated 2012 earnings of $8.64 renders a 2012
target price of $129.60. Relating that to the current stock price, we
project a compound annual return of 27.3%.
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Early payback periods provide defensive support, reducing downside risk.
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High expected return rates provide upside opportunity.