New Stock Valuation Model: Absolute PE Valuation

September 6, 2012 | Comments (9)

Written by

Jae Jun

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With the soon to be released new and improved Windows version (working on a MAC version) of the stock valuation spreadsheets, I’ve added a new stock valuation model to the spreadsheet.

It is one that I have written about previously called the Absolute PE Valuation model, created by Vitaliy Katsenelson and explained in his book, Active Value Investing.

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.

Basics of the Absolute PE Valuation Method

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.

Earnings Growth Rate and Dividend Yield.

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.

absolute pe valuation

Absolute PE Valuation – PE points

Business Risk

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.

Financial Risk

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.

Earnings Predictability

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
3. Earnings
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.

The Absolute PE Stock Valuation in Action

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.

High Growth Example – AAPL

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).

With such great fundamentals, the absolute PE valuation is saying that the fair value PE should be 22.55 resulting in an intrinsic value of $959.

Value Play Example – DELL

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.

So there you have it. A new valuation method making use of simple past trends to determine the quality of the business and whether there should be a premium or discount to the current PE.

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.

Disclosure

None.

  • http://www.facebook.com/renaud.monteslagunes Renaud Montes Lagunes

    Jae,
    Have you done back testing on this Absolute PE Valuation technique?

    thanks
    Renaud

  • hey

    Dell has a dividend now. I really like this as an additional valuation technique because it provides a range with just one parameter/assumption

  • http://www.oldschoolvalue.com/ Old School Value

    Oh right. That makes a big difference then. Here is the updated fair value PE showing 9.22 which means the fair value should be around $15.

  • http://www.oldschoolvalue.com/ Old School Value

    I haven’t but I believe the book goes over some of that.

  • Jessica

    how to measure the consistency/quality check?

  • http://www.oldschoolvalue.com/ Old School Value

    If you take a look at the screenshot, a company gets a point if a certain metric is greater or equal to the previous year. Also, if the standard deviation is a large number, it means there is a lot of fluctuation.

  • Hua

    Could share with us what are the max value that you assign for business risk, financial risk and earning visibility? How do you assign the value for these risks based on your metric?

  • JT

    How do you find the intrinsic value from this formula?

  • highlydubious

    love the addition, cant wait for a mac version, had to pay for VMware, Windows XP, and Office just to make it work… but of course its worth it

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