Valuation, Value Investing

On Time of P/E Mean Reversion vs Time when Competitive Advantage ends

When the P/E will mean revert (let it be T_pe) is independent from when the competitive advantage period (CAP) ends (let it be T_cap).

If (T_cap > T_pe), i.e. P/E mean reverts before the CAP ends,

  • Then it doesn’t matter, it just means that the projected selling prices (using mean reversion and good earnings growth) is A-OK, can be used.

If (T_cap < T_pe), i.e. CAP ends before P/E mean reverts,

  • You can still project good earnings growth for the CAP portion, and lousy earnings growth (at the cost of capital or no growth) for the time after the CAP. You can still pick a point as usual for the time of mean reversion – selling price and the corresponding IRR can still be calculated as usual.
  • Though the further out T_pe is, the more your performance will be penalised, as the required IRR of around 15% will be much higher than the lousy earnings growth rate (i.e. the calculated IRR will be pulled down significantly by the lousy earnings growth rate).
  • After the CAP, the earnings growth rate would have dropped, the P/E range might drop correspondingly. We can set the P/E (for the eventual selling price) to equal the lousy earnings growth rate for the period after the CAP.


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