To see the original and full explanation of the absolute PE method, read the post I linked to above, because I made some changes to how the variables are calculated in order to make the whole process easier to use and understand.
Let me show you how I’ve got it to work.
Here are the factors that make up the valuation model.
1. Earnings growth rate
2. Dividend yield
3. Business risk
4. Financial risk
5. and earnings visibility
The quick explanation is that the valuation starts with the current PE and then points are added or subtracted from the original to come up with an adjusted PE value.
I’ll show you how I’ve quantified each of the above points and how everything is put together to come up with a valuation.
Rather than trying to calculate difficult growth projections, the Absolute PE method, reverse engineers the PE ratio to come up with a growth rate according to the table below.
Benjamin Graham assigned a PE of 8.5 to no growth companies. In Katsenelson’s book, he assigns a PE of 8 for no growth. I personally assign a PE of 7 which has been working well.
If a stock also offers a dividend, it gets bonus PE points.
In order to quantify business risk, I went through various ratios and numbers to identify what makes a business good.
I’m sure that you will have a different definition of business risk, but what I’ve tried to do is come up with four items that the majority would agree with.
The four numbers I’ve identified capable of quantifying business risk are:
1. Return on Equity
2. Return on Assets
3. Cash Return on Invested Capital
4. Intangibles % of Book Value
The first three are self explanatory. Businesses capable of sustaining above average returns or increasing returns each year has a good business model, moat and capable management.
The fourth may need some explaining.
I’ve added intangibles as a percentage of book value because I do not want businesses to grow by acquisition which could lead to issues later on. Growth through intangibles is not a good business model and is not a competitive advantage.
High intangibles does not necessarily reflect business risk, but continually growing intangibles is a warning sign for sure.
The four numbers that make up financial risk are:
1. Current Ratio
2. Total Debt/Equity Ratio
3. Short Term Debt/Equity Ratio
4. FCF to Total Debt
A company with strong current ratio does not run the risk of going under.
Total debt/equity and short term debt/equity is included because total debt may not give the whole picture. A large upcoming debt payment is much more worrisome than a low interest, long term debt due in 10 years.
FCF/Total Debt displays the financial strength because it shows whether the company is able to pay back its debt through FCF instead of taking on new debt.
Trying to quantify earnings predictability is much more difficult, so I’ve tried to keep it as simple as possible.
1. Gross Margin
2. Net Margin
4. Cash from Operations
For a company to be predictable, it has to have stable margins, stable or increasing earnings and cash from operations. As much as I like FCF or owner earnings, I did not include it here because it is rather volatile and not a good measurement for predictability.
Numbers from the past 5 years and TTM is used to give a certain number of points to each criteria.
Let’s take a look at Salesforce.com (CRM)
and the way the points were calculated is as below (click to enlarge)
The business risk gets a below average score of 9 as the returns are horrible and fluctuates by a good amount.
Financial risk is above average and their earnings predictability is slightly above average.
CRM is difficult example because their EPS is negative and so there is no PE for CRM.
Let’s try AAPL. Huge growth with awesome fundamentals.
Based on its current PE of 15.8, the expected growth rate is 13%.
See how the points were calculated (click to enlarge).
Not surprisingly, DELL’s current PE of 6 has zero growth baked in.
If you enlarge and see the image below, look at the ROE. Although it is high, the standard deviation is also large which means that ROE is inconsistent and fluctuates quite a bit. This is not stable and if you see the standard deviation being too high, it is best to knock a couple of points off.
But based on the default values, the intrinsic value of DELL comes out to be the same as what it is going for now. The absolute PE stock valuation is saying that DELL is just an average company and it worth what it is.
Don’t forget to go through the original article on the Absolute PE model to see the formula and how it is calculated.
Let me know what you think.