Davis Double Play
The Davis Double Play is one of the key concepts in which Shelby Davis Sr. was able to achieve such incredible long-term returns.
Within in the realm of value investing, an investor is hoping for 2 things to happen:
- Earnings Growth (the company grows profits over time)
- P/E Expansion (the market assigns a higher multiple to those earnings)
Achieving growth in valuation (multiple expansion) is more likely when the stock was bought below its intrinsic value. Below, we'll walk through a simple example using a 10-year holding period.
- Initial Investment: $1,000
- Holding Period: 10 years
- Annual Earnings Growth: 10%
- P/E Ratio starts at 10x and increases to 20x over the period.
| Year | Earnings per Share (EPS) | EPS Growth | P/E Ratio | Stock Price | Investment Value |
|---|---|---|---|---|---|
| 0 | $1.00 | – | 10x | $10.00 | $1,000.00 |
| 10 | $2.59 | +10% CAGR | 20x | $51.80 | $5,180.00 |
So, the investment grew at an average of 18.15% per year, thanks to the combined effect of 10% earnings growth and P/E expansion from 10x to 20x. If the stock still traded at 10x earnings at the end of the holding period, the return would have only matched earnings growth (10%).
Unfortunately, this concept works in reverse also. Which is why it's critical to avoid paying too much. In the book, they example mention is a stock trading at 30x earnings. Assuming $1 earnings per share and a $30 stock price, if earnings get cut in half and the multiple that Mr. Market is willing to pay drops to 10, then the stock price will drop to $5.