So say the stock price today is $15, and the stock earns an EPS of $1 ie PE is 15x. Valuation expansion simply means that the stock should be $25 bcos PE should be 25x. The basis of this argument is that since the stock is in a growth industry, or has transformed its business, or watever crap reason, the future EPS is not just $1 but much higher. Since we are not sure what that would be, just give it a higher PE to justify this growth.
The ingenuity of this crap theory is that nothing changed, but the "value" of this stock just expanded 60%. This then can be used to justify buying the stock at any price bcos we can always assuming super normal growth and increase the valuation. We can even increase the target multiple further from 25x to 50x. This would expand the original "value" by 333%.
Let's just do a simple experiment the debunk this valuation expansion theory.
Yr 0 EPS $0.5 (Stock price $25, ie PE 50x)
Yr 1 EPS $1 (Stock price $25, ie PE 25x)
Yr 2 EPS $2
Yr 3 EPS $3
Yr 4 EPS $4
Average EPS $2.1
True intrinsic value (using PE 15x) = $2.1 x 15 = $31.5
Upside = $31.5/$25 = 26%
Upside per yr roughly 5%
So assuming today we are at Yr 0 and this company started out with an EPS of 50c but bcos of its super power growth, the stock market has already valued it at 50x PE current yr and 25x next yr. Of course this is assuming it didn't disappoint, its EPS doubled to $1. In fact it didn't disappoint for the next 4 yrs and its EPS grew from the initial 50c to $4. This stellar firm actually grew its earnings 8 folds in 5 yrs!
Now how spectacular can a normal company get? I would think this type of growth puts the world's best growth firm to shame. Look at APPL, the darling-est growth stock in our lives. Currently it's the 2nd biggest company in the world by market cap. Its net profit was $1.3bn 5 yrs ago. Last year, it was $8.3bn. The 5 yr growth alas is 6.4x, still a tad less than our hypothetical co. at 8x.
So 8 fold increase in EPS is really as good as it gets. But, if you have bought it for 25x or more, the return in stock price is likely to be single digit return. As I calculated, the intrinsic value is $31.5 vs today's price at $25. Of course, the stock might bounce up a lot, to say $50 then collapse, or it's price might continue to stay very much higher than its true value of $31.5, but we are value investors remember? We don't follow prices. We follow value.
What I am trying to say is this: when you buy a valuation expansion story, your rate of return is destined to be meager even if the story comes true. In our hypothetical case, the stock return over 5 yrs is about 5% per yr. How fantastic!
To me, valuation expansion is then just another variation of the Greater Fool Game. Valuation expansion means the earnings of the company is not great now, BUT bcos there are a lot of people willing to pay 25x now, therefore the stock price should rise by a huge magnitude.
I would think that a better way to make money would be the always buy below PE of 17-18x. Value investors would certainly do that. With valuation expansion, there is no margin of safety at all. What if the growth didnt come true? What if the genius CEO died?
So when you hear valuation expansion next time, pls beware!
PS: APPL did trade at 25x PE 5 yrs ago and you would have made a lot of money buying it at 25x 1 yr fwd and held it until today. But the better chance to buy was during the Lehman Crisis when the PE fell to 15x 1 yr fwd and you could have more than doubled your money in 2 yrs!