I would like to summarize my approach regarding the Potential Payback Period (PPP) and the Internal Rate of Return (IRR) for stock evaluation, from the very beginning.

In the 1980s, I noticed -- like all financial analysts and stock portfolio managers at that time -- that the Price Earnings Ratio (PER) was ill-suited to measure the "expensiveness" of a stock because it did not take earnings growth into account. A PER of 10 means that the stock's price capitalizes 10 times the earnings per share for the starting year or, in other words, it takes 10 years of future earnings to potentially recover the current stock price.

In this static perspective, it assumes that future earnings remain constant from year to year. However, in reality, these future earnings will grow at varying rates, and it is this "growth" factor that determines whether a stock is valued more or less "expensively" in terms of the multiple of earnings capitalization or PER. Therefore, the PER needs to be adjusted or relativized based on the earnings growth rate.

There are intuitive methods to "adjust" the PER, such as the one advocated by Jim Slater, which involves dividing the PER by the earnings growth rate. A stock is considered attractive only if the quotient is less than 1. This is an empirical and approximate method, perhaps useful in practice, but it lacks a rigorous theoretical foundation and cannot be applied in all circumstances.

The Potential Payback Period (PPP) adjusts or relativizes the PER in a more rigorous manner by introducing the projected earnings growth rate to calculate a potential payback period that equalizes the current stock price with the sum of future earnings per share. To do this, the PPP introduces this earnings growth rate into a mathematically logical formula. Thus, a PER of 10, meaning that it takes a "period" of 10 years to potentially recover the stock's price based on constant earnings, is immediately reduced (in terms of years) if we lift the assumption of constant earnings. Assuming, for example, a profit growth rate of 8% per year, the compounding effect brings the new adjusted PER, now called PPP, to 7.64 years. With a growth rate of 15%, the PPP would be only 6.56 years. Thus, the PPP better measures the value of stocks by rigorously and precisely adjusting the PER based on the expected earnings growth, enabling more meaningful and more detailed comparisons.


The graph below shows the relationship between PPP and PER under different earnings growth rate assumptions.

How the PPP varies with respect to the PER

Another essential contribution of the PPP to stock evaluation is the consideration of interest rates that characterize the financial markets at any given time. Indeed, to be more comprehensive, the PPP equates -- over a specific duration -- the stock's price with the present value of future earnings. The discount rate used is none other than the long-term bond yield, which represents an alternative investment to stocks. The choice of this discount rate reflects the notion of opportunity cost because if we buy stocks, we forego the yield offered by bonds.

In practice, we indeed observe that, all else being equal, when interest rates rise, stock prices fall, and vice versa. The formula of the PPP explains and quantifies these opposite movements, as the PPP lengthens -- making stocks less attractive -- when the interest rate increases, and vice versa.

Thirty years ago, I published PPP tables that have become obsolete with the widespread use of computers and automatic calculation programs.

This PPP concept was explained in several issues of the French-based magazine “Analyse Financière” in the 1980s, as well as in the reference book "Finance d'Entreprise" (Corporate finance) by Pierre Vernimmen, a professor at France’s most prestigious business school named HEC.


More recently I started to develop the PPP concept further to make it a more concrete and practical evaluation tool for stocks while keeping it closely related to corporate finance for the sake of rigor. This approach naturally led to the "Internal Rate of Return" (IRR) applied to stocks.

From a stock’s PPP we can deduce its IRR, knowing that both the PPP and IRR are common instruments for selecting investments in corporate finance. In corporate finance, the IRR is the discount rate that equates the amount of an investment with the expected net cash flows from that investment over its life. By applying this corporate finance concept to an investment in a stock and taking the PPP as the investment's duration, we can extract a precise Internal Rate of Return corresponding to each PPP value. In other words, the redefined IRR as an instrument for evaluating a stock is the discount rate that allows an investor in a given stock to potentially double their investment through the cumulative earnings per share over the calculated PPP period for that stock.

Expressed as a percentage, the IRR is more concrete and meaningful in conveying the attractiveness and opportunity of an investment, whether for an industrial investment or an investment in a stock market.

In the calculation method one can directly move from a "PER - Earnings growth rate" pair to the IRR without going through the PPP.


Let's take the example of three stocks A, B, and C with the following characteristics:

- Stock A: PER of 8 and earnings growth rate of 3% per year.
- Stock B: PER of 13 and earnings growth rate of 18% per year.
- Stock C: PER of 25 and earnings growth rate of 38% per year.

First, we can ask which of these three stocks is the most attractive, given that they have significantly different PERs? In the assumption of an interest rate = 0%, these three stocks have the same PPP (7.3 years) and the same IRR (10.0%).

But in the scenario where the long-term bond yield rises to 4%, the IRR for A, B, and C drops to 8.73%, 9.04%, and 9.25%, all else being equal. This simulation shows that high-growth stocks with high PERs are less affected by an increase in interest rates.

We can also make an international comparison where an interest rate differential (r) adds to an earnings growth rate differential (g) to compensate for a wide PER differential (ranging from half to double) and practically ensure the same profitability or return (IRR) for two apparently very different stocks A and B:

Stock A: r = 4%, g = +6%, PER = 10 -----> IRR = 7.67%
Stock B: r = 0%, g = +18%, PER = 20 -----> IRR = 7.81%

Even with a PER twice as high (20 compared to 10), B is actually more attractive than A because its IRR (7.81%) is higher than that of A (7.67%).


The PP and IRR allow for testing the rationality and homogeneity of financial markets. If one relies solely on the PER to assess the "expensiveness" of stocks, one can arrive at absurd order-of-magnitude values. Indeed, the PER can reach astronomical amounts when the earnings per share for the chosen year is close to zero, and it also loses all meaning in case of losses for the year under consideration. On the other hand, the PPP varies -- in all cases -- over a narrower range of 5 to 15 years, corresponding to an IRR that varies -- in the opposite direction of the PPP -- from 15 to 5%. These PPP and IRR figures can be considered significant, realistic, and credible due to their reasonable order of magnitude and relative stability, reflecting the rationality and homogeneity of financial markets, as shown in the graph below depicting the evolution of the IRR as a function of the PPP.

How the IRR varies with respect to the PPP

The return of a stock should not be confused with its yield. While the yield of a stock is measured solely in relation to the dividend paid, the Internal Rate of Return reflects operating performance and measures the earnings-generating capacity of the company represented by the stock in question, which suggests a capital gain for the stock investor alongside earnings growth.

I hope that these reflections regarding the PPP and IRR will stimulate reactions from professionals in the stock market who are now familiar with rigorous analytical approaches. I hope that those interested will continue to develop this sort of approach and help to enrich my research aimed at evaluating stocks in a more rational manner based on fundamental factors.

Sam Rainsy