@Rick i thought you would like this article from seeking alpha by cory cramer..enjoy
Introduction
Markets, as most of us know, can get a little crazy sometimes. Over the centuries various bubbles have expanded and popped, from tulips to real estate, to profitless companies promising to revolutionize the world. And it's not only fools and gamblers who have gotten caught up in them. Pure intelligence does not inoculate us against being infected by these manias. For example, one of the most intelligent men of his age, Sir Isaac Newton, is reported to have lost the equivalent of $40 million in the South Sea bubble in the 1700s. His IQ didn't save his fortune. On the flip side, we might be tempted to think that "if someone as smart as Newton couldn't avoid these busts, then it is hopeless for us mere mortals to do so", but nothing could be further from the truth. There is a very simple metric that every investor should use, which goes a very long way in preventing the worst mistakes of this sort. I will share that metric and how I use it in this article.
But before I proceed I want to give proper credit to Warren Buffett because he inspired this metric and way of thinking. Around 10 years ago I watched an interview he gave with Becky Quick when she asked him about his Burlington Northern railroad purchase, and Buffett replied that the business had "already paid for itself". This response stuck with me for quite some time. Burlington Northern was at that point a private business, so unlike, say, Buffett's later purchase of Apple (AAPL) stock, the price of which had more than doubled since his purchase, there was no stock quote available for BNSF. So, Buffett wasn't saying that BNSF's stock price had more than doubled. What Buffett likely meant was that BNSF's earnings since his purchase had met or exceeded his purchase price of the business. (Or, at least that was my interpretation.) I thought about this concept for several years and eventually converted it into a useful metric. So, thanks, Mr. Buffett, for the inspiration. (As a side note, when I talk to small business owners, I often hear a similar way of thinking about specific endeavors they have taken, like "that rental property paid for itself in 5 years", or, "that new store has paid for itself already". But it is much less common with stock investors.)
One additional note before we move on is that this is an investing metric, which is meant to be used by investors. It's not a trading metric. Investing metrics can be used for both private and public businesses. These are fundamental business numbers like earnings, cash flows, etc. Stock prices or publicly quoted prices for assets or commodities are trading metrics. In short, if something requires a sale of an asset to a different person at a higher price in order to produce a profit, that's trading. If a business is purchased, a profit can be made from the business's earnings without a sale of the business. At its core, this concept is pretty simple, but trading and investing are often confused, or at least mixed together as though they were the same thing in the financial media, and I want to make this distinction clear at the outset. Traders don't need to bother themselves with this approach, investors, however, do.
Time Until Payback
The metric every investor should know or estimate before making an investment is how long they expect it will take to earn an amount equal to their initial investment back via the earnings (or via cash flow, owner's earnings, interest, rent, or some similar metric). So, if you invest $100 per share into a business, how long will it take for the business to earn $100 per share in earnings? It's very simple on its face. An investor can do this with stocks, bonds, rental properties, and almost anything that produces a return via earnings or interest. However, it is not very useful for trading. Things like crypto, commodities, unproductive real estate, depreciating "assets", and the stocks of businesses without earnings prospects, cannot have a time until payback metric because they rely on being sold to someone else at a higher price than they were purchased in order to be profitable. Businesses can be traded too, of course, but that is different than investing. Requiring a time until payback metric from an investment will eliminate a lot of bad 'investments' right out of the gate because they aren't investments anyway. Many other bad investments will be eliminated from consideration once some basic math is performed and the investors think about how long it might take to earn an amount equal to their investment back using reasonable assumptions.
My preferred way to calculate the Time Until Payback or "TUP" is to use adjusted earnings. I've found it's the quickest to calculate as a starting point for a simple valuation, then if the numbers look interesting, I make adjustments for things like debt and potentially management's "adjustments" that may not seem reasonable to me. In this example, will share a very basic method using the S&P 500 ETF (NYSEARCA:SPY), and then I'll discuss some additional considerations and adjustments I often make with individual stocks.
There are only two pieces of information an investor needs in order to perform this analysis: The starting Earnings Yield, and the expected Earnings Growth. Those two pieces of information can produce an expected Time Until Payback. The TUP is expressed in years, and the lower the number of years it takes an investment to earn an amount equal to the initial investment, the more attractive the investment is. The longer it takes, the less attractive the investment is.
FAST Graphs
In my first demonstration, I am going to keep things very simple and pull the earnings yield and historical earnings growth right off the FAST Graph for SPY (they are circled in green). The earnings yield is 3.96% and the earnings per share growth rate during the decade from 2015-2024 has been +7.94%.
The way I think about this is that if I bought the whole company for $100, then a 3.96% earnings yield means the company would earn $3.96 the first year of ownership. I could take those earnings if I owned the business and spend them on whatever I wanted. The next year, earnings could be expected to grow +7.94%, so the $3.96 of earnings would be $4.27, and after two years, we would have collected $8.23 of earnings from the business. I want to know how many years it would take to earn my initial $100 investment back using this estimation process. In reality, when I do this I always pull the first year's earnings growth forward because there are times, like now, when we are almost at the end of the year and I want to include the growth that will happen next year, so I would start this calculation assuming $4.27 in earnings on a $100 investment could be collected the first year, and go on from there.
YearEarnings per $100Cumulative Earnings1$4.27$4.272$4.61$8.883$4.98$13.864$5.38$19.245$5.80$25.046$6.26$31.307$6.76$38.068$7.30$45.369$7.88$53.2410$8.50$61.7411$9.18$70.9212$9.91$80.8313$10.69$91.5214$11.54$103.0614-15 Year TUP
Using the above estimates, the time it would take to earn one's money back from the S&P 500 businesses if the next decade has similar earnings growth as the past decade is 14 to 15 years. Each investor has to decide for themselves the length of time they think represents a good return on their investment. That said, historically, the historical average TUP for the S&P 500 is around 9 to 10 years depending on the time frame chosen. To get above-average returns, I typically aim for about a maximum 8 to 9-year TUP when I buy stocks, and most of Warren Buffett's bigger public stock purchases had about an 8-year TUP when he bought them. Apple, for example, had about an 8-year TUP when Berkshire started buying, and now Berkshire is selling when Apple has a 16-year TUP if we assume 10% earnings growth. This might not sound like such a big deal, but, assuming one can continue to find investments to reinvest earnings with an 8-year TUP, the 16-year TUP investment of $100 will return $300 additional dollars ($400 total, doubling twice) over 32 years while the 8-year TUP investment will return $1,500 additional dollars ($1,600 total, doubling 4 times). (This is why Mr. Buffett is so rich, he knows how to compound earnings.) With the S&P 500 at 14 to 15 years Time Until Payback, it's unlikely to be a lucrative investment over the long term from here given the earnings growth assumptions I used.
Additional Considerations
The basic Time Until Payback metric is pretty simple at its core and will certainly serve to keep investors from making a lot of bad investments, but there are still a lot of decisions investors need to make when it comes to choosing what best represents the current earnings yield, and the expected earnings growth rate. With the earnings yield, I prefer to include debt and other obligations in addition to the market cap, so I usually use the Total Enterprise Value instead of the Market Cap. That is the primary adjustment I make when it comes to determining the earnings yield (though on rare occasions sometimes I also will use GAAP or basic earnings instead of adjusted earnings if they seem more reasonable). Also, investors must understand how cyclical earnings for a business typically are. If earnings are deeply cyclical, it can be difficult to perform this type of earnings analysis because earnings can change so much from year to year. For that reason, I use a different type of analysis for companies that have a history of earnings declining more than -50% during downturns. (It's not impossible to use a TUP analysis with cyclical businesses, but one would need to make an assumption about what the average baseline in initial earnings would be in order to get a good read the earnings yield.)
Determining the expected earnings growth tends to have a lot more judgment involved. My preference is to use the previous economic cycle's earnings per share growth rate, while taking into account years in which earnings growth might have been negative, and also backing out share buybacks because they can inflate the earnings per share growth over time. This process usually gives me a more conservative earnings growth rate expectation than simply measuring point to point over a decade and assuming earnings grew at a smooth and steady rate. Using historical earnings is naturally a backward-looking approach, but I've found that about 80% of the time it's reasonably accurate as long as we are on guard for recently slowing growth. If I see that trend, I might use the more recent and conservative numbers or even analysts' forecasts if they are more conservative rather than the historical rate.
My observation has been the market tends to use analysts' 12-month forecasts for earnings growth, and then extrapolate that rate out far into the future. For example, analysts are expecting about a 15% earnings growth rate for the S&P 500 over the next couple of years. That's about double the earnings growth rate expectation I used earlier in my analysis based on recent history. If we use this 15% earnings growth rate for SPY, the Time Until Payback drops down to 11 years. This information can be useful because it helps investors like myself know where it is I might be in disagreement with the market and who seems more reasonable. I think assuming the S&P 500 can grow earnings by 15% per year over the next decade without a recession is very optimistic, and I'm willing to take the under on that, so this is a case where I think I'm being more reasonable, but each investor can decide that for themselves.
Conclusion
Of course, there are many decisions an investor must make when it comes to estimating earnings and future earnings growth, but some form of this Time Until Payback calculation ought to occur for most investments. The metric isn't limited to stocks. It can be used for bonds, rental properties, and private businesses as well. It's more difficult or impossible to calculate for speculative trading vehicles like crypto and businesses that don't seem to have profits on the horizon, or many ETFs, that, unlike SPY, don't have easily accessible earnings data. Requiring some version of this metric can help investors avoid a lot of the speculative trading vehicles currently masquerading as investments, which in turn can help avoid the worst of speculative bubbles.
