1. A significant increase in earnings per share;
2. A significant increase in the price-earnings ratio that investors will be willing to pay for this company’s stock.
Take the example of a company in which we invested 11 years ago, and which has since provided us with excellent stock market returns: Visa.
At that time, Visa’s stock was worth about $18 (all data that follows is adjusted for a subsequent 4-to-1 split) and was valued at nearly 15 times expected earnings. This was a relatively low valuation ratio compared to its historical valuation due to concerns that the US government could regulate debit transactions and thereby materially reduce the profitability of such transactions for Visa (and Mastercard).
However, we have clearly benefited from a double-barrelled advantage with Visa.
First, earnings per share grew from $0.99 in 2010 (Visa’s fiscal year ends September) to $5.86 in 2021. This is a compound annual growth rate of 17.6%.
Second, the price-earnings ratio afforded by investors in Visa has gone from nearly 15.0 in 2011 to about 31.0 times the expected 2022 earnings at present.
These two factors combined have taken the stock from nearly $18 in 2011 to its recent price of $220. This is a compound annual return of 25.6%.
I believe it is the job of any investor to try to find these advantages. To do this, one must look for companies that have the potential to significantly increase their profits over the next 5 or 10 years. I personally believe that you increase your chances of finding such companies by focusing on those that have already proven themselves and are already profitable and growing. We should also try to identify companies that have developed a long-term sustainable business model that is protected from competitors by high barriers to entry.
Once such companies are identified, an investor should attempt to purchase their security at a reasonable valuation level. Ideally, one should see the potential for the price-earnings ratio to increase over the years, as had been the case with Visa’s stock. By paying reasonable valuation ratios, the investor not only increases the long-term return potential, but also substantially reduces the downside risk in the event that one was mistaken about the company’s earnings growth prospects.
The recipe for obtaining high yields is therefore very simple, but its application is far from easy!
