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## Revaluing Shares In A Downward Market

As I watched share prices fall today, I’ve been considering how my previous calculations were all based around an expected minimum return of 5% pa after tax and whether or not this is valid anymore. The reason for this consideration is that there are some defensive stocks that I believe will continue to be profitable during the oncoming fray which appear as bargains using my previous formulae.

Before discussing this further I will share how I arrived at the value of an expected minimum return of 5% for my calculations. The value of 5% was basically the sum of the Risk Free Rate (which is the rate you can invest your money with theoretically zero risk – in my case my mortgage rate) plus a generic Risk Premium (representative of risks to the economy, outside of those factored into expected future return for the specific company) plus the amount I would like to make for taking that risk after considering tax (because my investment proposition is based on the return I want to make for myself, not the IRD).

In the derivation of the value of the 5% lies the problem, which is that the Risk Free Rate has increased and is set to increase in the coming year or more; hence the cause for concern over inflation for investors. Additionally the Risk Premium has also increased to reflect the level of uncertainty and negative sentiment for the future economy. Therefore it seems obvious that shares cannot be valued using my previous calculations.

I’ve already talked about how PE is no longer a good way to value stocks because it assumes a linear, constant progression of company earnings, but as you can see, there are some fundamental components to the way PE should be used that are also falling apart because it’s harder to assign a Risk Premium and Risk Free Rates are changing and unpredictable in the term that I look to invest in (years).

There are two components to calculating value in a company using PE: Firstly calculating the PE, then calculating what PE is appropriate for that particular company.

Lewis Hurst

The problem with investing in your Risk Free Rate option is that there’s also no risk of upside. This may change my financial models if we spend too long in these doldrums. Whatever the state of my modelling, it seems that I have no other course of action than to wait until the future of OCR changes becomes clearer, which will be preceded by tamed inflation; inflation being a sign of how the Risk Premium will be affected, also.

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## Why PE Is No Longer A Good Way To Value Shares

Long time readers of my blog will have realised by now that I love to use PE to value shares (with the exception of angel investment, because it’s more complicated). I have a very handy set of graphs I use to show the value in PE over time, which I use to discern what PE is appropriate for any given growth. I like this method because it’s quick and easy so I’m less likely to make a mistake. It’s also shortsighted, looking only a few years ahead, which is great because my experience of business tells me that predictions looking further than a year are guesses anyway.

Unfortunately, given the downward outlook for the economy, my graphs have become irrelevant as they all model positive trajectories. I contemplated making new graphs assuming negative growth, but figured that there’s no point without calculating future growth beyond the negative – otherwise where is the value in buying such a stock?

A poster on ShareTrader.co.nz (I think it might have been Winner69) stated that a PE valuation is just an abstraction of a DCF valuation (or words to that effect), and I wholeheartedly agree with that statement and it’s something I’ve opined to myself before, though I would append just two extra parts to that:

A PE valuation is an abstraction of a DCF valuation, that is shortsighted and only accounts for unidirectional growth at a constant rate.

Lewis Hurst

It is in this statement that belies the fault in using PE for valuations in the current stock market; growth will likely be neither unidirectional or constant.

Therefore I posit that presently some form of DCF valuation is a more appropriate way to value listed shares in the current market, though it’s also worth remembering that any valuation methodology would have to be selected / designed with your investment strategy in mind. On that note, I feel that dividend / income investors (such as myself) should also be considering value based on a DCF rather than potential dividend value, because as profits diminish and business risks increase, dividends can be cut disproportionately to the market value of the stock; hence a dividend based valuation could price you out of the market and cause you to invest later than you otherwise would, which would end up reducing your dividend yield.

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## What Is A Good PE?

The Price-to-Earnings ratio (PE) that you are willing to pay for a company should depend on three things: the growth rate of the company, the time frame of your investment and your expected return.

If you are happy with 5% annual return on investment (ROI), assuming either the company pays out 100% of it’s earnings in dividends, or you perceive the value to be retained in the company to be part of your return, a PE of 20 is what you should strive for (5% being the whole company divided into 20, or 100 / 20 = 5).

If a company has zero growth and this is always true, a PE of 20 will eternally get you your 5% ROI. But if the company is growing, and you pay a PE of 20, then each year the PE will improve on the former year (inflation excluded). This is where the other part of my statement comes into play, whereby the growth rate and time frame of your investment will effect the PE you need to pay to get a PE of 20 within your given time frame.

In other words, if you are happy with a PE of 20, but don’t mind waiting a year for the price you paid to become a PE of 20 after a few years growth, you would be willing to pay a PE of greater than 20 to get a better return in years to come.

For example, if you pay \$100 for a share of a company that has \$4 worth of Earnings Per Share (EPS), you’ve paid a PE of 25 (100 / 4 = 25). If that company grows EPS to \$5, you effectively paid a PE of 20 (100 / 5 = 20). If you’re investment time frame is a few years, you might be happy to wait for the PE to take a year to get to an acceptable level, especially knowing that years after, with more growth, your effective PE would be much less than 20.

Here are 3 graphs I’ve created showing how PE changes over time based on an initial purchase at a specific PE for companies with different annual growth rates. The different graphs show how a higher purchase price extends the time frame for the investment to become acceptable.

This should help calculate a good PE to buy shares at, based on your expected ROI, time frame and the growth rate of the company.

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## Calculating PE, My Proprietary Method

I would like to share my proprietary method for calculating Price to Earnings (PE) ratio. I’m happy to share this IP with you, you are free to use it as you wish or discard it.

The reason I created this method of calculating PE is because I wanted a metric that I could use to calculate how much value there was in a business. For me, a traditional PE calculation doesn’t consider the total amount of money that you could get for your investment because dividends are removed from the earnings calculation and it doesn’t consider how much equity (in cash and cash alternatives) that a company could use to pay out to it’s shareholders. This is my proprietary PE calculation:

(Market Capitalization – (cash + cash alternatives)) / NPAT

Lewis Hurst

This equation effectively gives you the part of the business your buying divided by the amount of money you could potentially receive.

## Why Remove Cash And Cash Alternatives From the MC?

If a company’s Market Capitalization (MC) is \$100M and the company has \$99M in the bank, if you bought the business you’d own the \$99M in the bank. Effectively the business cost only \$1M, which is why I think it’s a more reasonable value to use than the MC alone.

The equation doesn’t add debt to the MC because even though you inherit the debt when you buy a company, you could view the interest as an expense like any other, which is taken into consideration by the NPAT.

## Why Divide By NPAT?

I like to divide by NPAT instead of Net Income – Dividends, because NPAT is the amount of money that could come out of the company and go straight into your pocket. It’s the reason to invest and the value that’s generated by the company, as I see it. I don’t use figures before tax because I don’t consider how much I can help the tax man as part of my investment rationale when building a case about whether an investment is worthwhile.

I suppose you could call this an APNPAT (Adjusted Price to NPAT) ratio, instead of a PE ratio. As usual, different companies have different structures, risks and growth rates, which effects what metrics you might consider using in your investment proposition. Another factor is obviously your exit strategy. I probably wouldn’t use such a metric for an investment where the exit strategy was a sale, a traditional PE would be better in this case. However, if I were buying for dividend growth, I find this metric better.

I’d love to hear your constructive feedback in the comments below, and also any of your own valuation calculations that you’d like to share.

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## How To Calculate PE

PE, or Price to Earnings ratio is a measure of a company’s price, relative to it’s earnings. It can either be measured as a forward looking metric or a backwards looking metric.

To calculate the PE of a company, you divide it’s Market Capitalization (MC) by it’s earnings, or Net Income – Dividends. To calculate the forward PE, you use projected earnings (forecast by you or the company); to calculate the backwards PE, you use the earnings from the most recent financial report.

PE is a sort of valuation method to see if a company is worth investing in at it’s current price. You can think of the PE as the number of years you’d have to own a share in the company before the company earned enough money to cover the cost if your purchase (assuming earnings are the same each year).

For example, if a company’s MC is \$100M and it’s earnings are \$10M, the PE would be 10 (100 / 10 = 10). After 10 years of earning \$10M, the company would have made \$100M (excluding amortization & interest on the value of the money).

Assuming all this money is paid out in dividends, the investor would have made their money back. In this scenario, a PE of 10 might be considered as a 10% ROI.

Depending on several factors, such as risk, market sentiment, the growth rate of a company and expected return, an investor might be willing to buy a company at a higher or lower PE.

A fair PE for a company with zero annual growth might be 11, while a company growing at a fast rate might command a higher PE, such as 25 – 40. The PE that you are willing to accept is directly related to the amount of return you want to achieve on your investment – it is this factor that brings market sentiment into the equation.

It’s worth considering that this method of calculating value in a stock price doesn’t consider growth of a company sourced from investing profits back into the company before realizing them on a balance sheet, which is a tax efficient way to grow the company. PE is more suited to valuing mature companies, or growth companies with a significant profit margin. PE also doesn’t show value in a company that is not profitable.

This method is a provides a very real perspective of the Return On Investment (ROI) because it considers the part of the profits that are held by the company – though it’s important to ensure that if those profits which were held back are reinvested, that they do actually translate into growth. Otherwise they are just a poorly reported costs of doing business.

Finally, please feel free to check out my own proprietary method for calculating PE.