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Could You Have Predicted Diamond Foods Accounting Fraud?

January 30th, 2012 by Jae Jun

Written by

Jae Jun

Here is a good case study to go through.

Diamond Foods (DMND) is being investigated by the SEC and DoJ for potential accounting fraud.

I will go through a few methods to detect earnings quality, manipulation and aggressive accounting to see how well it comes up against DMND.

So as we go through this, the question is, could you have identified DMND’s accounting shenanigans in advance by using such methods?

Accounting Fraud Accusation against DMND

From the Forbes article,

“Allegedly, the company delivered so-called “momentum payments” to walnut farmers in order cook their earnings filings.”

Momentum payments mean that DMND paid their suppliers in advance. Future expenses is shifted to an earlier period which will inflate earnings.

If the audit proves to be true, then based on a Bloomberg magazine article (no link sorry), DMND’s 2011 earnings will be reinstated from $2.22 to $1.14. That’s close to 50%. Ouch!

Earnings Shenanigans

In Financial Shenanigans, shifting expenses to another period is clearly defined as one of the shenanigans used to manipulate earnings. Now in the Bloomberg article, Mendes, the CEO, is portrayed as a very ambitious and business aggressive man. If the article is true, that “could” explain the aggressiveness in the accounting.

If you have read The Art of Short Selling, you will know that there have been many companies throughout history where such CEO characteristics have led to accounting frauds.

Balance Sheet Check

Let’s get down to the numbers.

Take a quick glance at the balance sheet. Even though a company like Diamond Foods is all about the brand of its products, the balance sheet is very unattractive. Just looking at the total intangibles should immediately raise red flags.

66% of total assets is made up of intangibles.

Accrual Ratios

Previously I went through examples of how to analyze accruals. One of the examples featured Dolby (DLB) where accruals were consistently above 25% for 4 years, yet DLB increased cash and reduced debt. DLB’s Sloan ratio was higher than the recommended 8%, but nothing jumped out and the result was inconclusive.

However, take a look at DMND below. (These numbers are from my stock analyzer and the model will be included in the next update.)

Cash balance is close to zero, debt has sky rocketed with all the acquisitions, net income is increasing but cash flow from operations is erratic. Dangerous signs already.

The accruals for 2009 and 2010 is shocking. In 2010 and 2011, there is a very good chance that DMND’s growth in EPS came from accruals. In other words, low quality and cookie jar type earnings.

Beneish M (Manipulation) Score

The third method you can use is the Beneish M score to detect earnings manipulation. Full details of how this model works is in the Beneish M Score article.

A score greater than -2.22 indicates a strong likelihood of a firm being a manipulator.

Coincidentally, the 2009 and 2010 numbers are red flagged.

Conclusion?

By checking the balance sheet, accruals and M score, warnings are flashing everywhere. DMND is innocent until proven guilty, but by my definition, shifting expenses to inflate earnings is fraud.

Summing up, do you:

Disclosure

No position in DMND

Posted in Valuation Methods | 21 Comments »

Checking Accruals of a Company in 5 Minutes

December 27th, 2011 by Jae Jun

Written by

Jae Jun

A week or so ago, I had a guest post about accruals and determining quality of earnings. I hadn’t heard much about it before then so I did some reading am finding it increasingly interesting.

Interesting and useful enough to create an accrual analysis section in the stock valuation models.

Rather than going over the whole accrual topic again, read the article on determining earnings quality through accruals.

Signal of Future Stock Performance?

Based on a 6 page report (pdf) produced by Bernstein Investment Management and Research, companies with low balance sheet accruals out performed companies with high balance sheet accruals by 8-10%.

Other than the equations for finding the accrual ratios from the previous post, I don’t have any information on how Bernstein modified their conditions to get the results, but the theory is the same and is important to understand.

Cash Flow vs Accrual Accounting

Majority of my focus has been on cash flow where there is less room for accounting manipulation because in the real world, we pay cash for something and receive cash for products or services rendered.

This is an ideal scenario and is basically means that earnings should equal the change in cash.

However, this would cause accounting issues as a business could spend a lot of money building inventory one year and not selling it until the next.

Accrual accounting attempts to fix such issues by matching costs with related revenues but he problem is that this method introduces subjective judgments and assumptions.

Here are some other quick observations regarding accrual accounting you need to understand.

Accrual Accounting Observations

(Read the PDF for detailed explanations.)

  • Earnings growth due to accrual growth is not sustainable. This is like cookie jar accounting where a company “borrows” earnings from the future to make earnings look good today.
  • Balance sheet accrual can indicate whether capital is being used properly. A company with high accruals can come from acquiring or merging with companies which expands the asset base. Low balance sheet accrual companies tend to shrink their balance sheet through spin offs, share repurchases or large write offs. In these situations, it is usually removing bad performing assets or returning money to shareholders which is always a good use of capital.
  • High accruals indicate that the company has expanded its asset base rapidly.
  • Companies with high balance sheet accruals tend to have higher sales growth than low balance sheet accrual companies.
  • High balance sheet accruals also have a higher ROE.
  • Remember that maintaining a high sales growth or high ROE is difficult unless you have an entrenched moat. Such companies revert to the mean and disappoints analysts.
  • Companies with low balance sheet accruals tend to have below average returns on equity. Analysts expect the company to lag.

All of this sounds a like regular value investing and contrarian investing principles.

Examples to Analyze

Let’s analyze an example to nail the concepts into our heads. You and I have the benefit of hindsight bias with these examples.

I’ve chosen DLB as my first example because it is a current holding of mine and it’s always a good idea to challenge current holdings with new ideas.

Both the balance sheet and cash flow accrual for DLB has been growing quickly. The accrual ratios suggest that DLB relies on accruals to post positive earnings. But the assumption can’t just end there.

Cash has been increasing with decreasing debt, total liabilities well under control with consistently increasing net income.

If net income drops with accruals increasing, watch out.

The Sloan ratio is best when kept below 8%. You see in 2007 – 2009, it was much too high. It may have been that all those accruals finally got to the stock price in 2010 as it hit $70. Then with news that DLB won’t be included in Windows 8, the stock reverted to the mean level where all future revenue for Windows 8 is removed.

Do Accruals Indicate Stock Performance?

I must have gone through about 20 companies to try and find a obvious example, but it is much harder to find that I thought. Many companies with horrible accruals ended up shooting up with a stock price still strong after 5 years.

I’m not surprised though because the accrual ratio is still just one way of analyzing a company’s health.

A better way to go about doing it would be to compare direct competitors to see how the ratios stand within the industry.

Your Homework

Here is your  mission. Go through the numbers quickly for Western Digital (WDC) and tell me what you think about its accruals.

You shouldn’t take more than 5 minutes.

There is no right or wrong answer as this analysis still involves some subjective thought processing.

Final Thoughts

Red warnings signs won’t show up for every stock that you look at. If you do this exercise with AAPL, you will notice that it breaks all rules. As a cash flow investor, I’ve focused most of my energy on the cash flow until now, but understanding how that cash flow is related to earnings is a great check to include in your analysis.

The accrual ratios won’t help you find killer investments, but it will help with building a healthy portfolio. I’ve yet to see how I can fully maximize the lessons from here myself, but I will definitely be including a check in the accruals in my investment process and stock valuation models to speed things up.

Posted in Featured, Valuation Methods | 6 Comments »

3 Ways You can Find Out What the Market Expects

December 15th, 2011 by Jae Jun

Written by

Jae Jun

I’ve recently been putting more weight to the question of “What are the expectations for this stock?”.

Rather than purely concentrating on a bottom up approach where I value the assets, cash flow and growth to come up with a range of intrinsic values, questioning what the markets expects out of the stock adds another dimension to the valuation process.

Based on Historical Data

When performing any stock valuation, you are extrapolating numbers based on historical data.

e.g. DCF could come out to $40, Graham’s formula shows the stock to be worth $65 and EPV gives a conservative $30.

Which one is correct? Can you assume that the range is $30 – $65 and invest in the company comfortably?

By figuring out what the expectations are, you can take it one step further. In other words, invert the valuation.

Understand What the Crowd is Saying

In Mauboussin’s book More than You Know, he writes of an experiment that was played out in a university  classroom. The professor has a large jar of jelly beans and asks a student to guess how many jelly beans were contained in that jar.

The first student gives an answer way off the mark.

The professor repeats this process for each student in the room.

At the end, not one student got the correct answer. The range of values were high, with many incorrect answers.

However, the average of all the answers turned out to be the closet to the jelly bean count.

The market works like this. You have millions of individuals offering differing opinions. Value investors will provide conservative estimates, growth investors will provides extreme estimates. No single person may be correct, but over time, the value will be recognized by the market.

I’m not putting forth an argument that the market is efficient. My point is that understanding how the market thinks about the stock is important. Does Mr Market know more than you or does he know less?

Reverse Engineering Valuation Methods

The additional questions you should now be asking  yourself are the following:

1) What is this stock worth?

2) What is this stock NOT worth?

And here are a few methods of how to go about answering these questions the inverse way.

Reverse DCF

A reverse DCF valuation will help you find the expected growth rate the market is pricing in.

Set the discount rate to something that is reasonable. For small caps, a discount rate of 12-15% is desired. For large caps, 9% discount rate is satisfactory.

However, an easy way to find your desirable discount rate is:

Discount rate = Risk Free Rate + Risk Premium

Asset Valuation

Use this simple equation to see what the expectations are.

stock price = assets + expectations (a.k.a growth or speculative value)

If the stock price is made up of a lot of assets, not much growth is expected. If the company can either perform at the GDP rate (around 4-5%) then you have a good chance of finding a winner.

If the stock price is made up of little assets, there is a likely chance that the company will disappoint in the near future.

Reverse Earnings Valuation

This reverse earnings power value next one is more complex and based off expected earnings power. Think of it as a reverse EPV.

1. Create your multiple

2. Calculate Excess Cash of interest bearing debt into a per share price

3. Deduct Excess Cash per share price from the current market price of the stock

4. Divide remaining amount by the multiple in step 1

5. Determine a proper earnings growth rate or use an analysts assumption to draw ideas on (don’t rely on the analysts information – just use it to see what information you can derive from it)

6. Find how long it would take to grow shares from what they are currently to what Step 4 produced using the assumed growth rate

7. Determine in your own mind using logic and rationality how feasible the proposition is based on the information at hand

Invert the Problem to See What the Market Expects

There are other ways of reverse valuation, which I’ll walk you through another time, but one thing that becomes clear is that once you start doing this, your questioning and thought process starts to change.

Posted in Valuation Methods | 9 Comments »

You Need to Determine Earnings Quality Through Accruals

December 12th, 2011 by Jae Jun

Guest post by

James DeMasi

Seraphin Group

When you’re trying to value businesses then you’re primarily going to be trying to put a value on their earnings power.  We all like to see big earnings, but quantity is much less important than quality.  Earnings can be considered high quality when they are both repeatable and accurately represent the company’s operations.  This may not always be the case because of fraud, misreporting, and managerial accounting discretion.  You can begin to determine whether or not a company has high quality earnings by checking on its accruals.

Net income is a product of accrual accounting

Businesses make sales by either collecting cash or extending credit to their customers.  Therefore, in the simplest terms, a company’s accounting earnings are equal to its cash earnings plus accruals.  But, managers can manipulate accounting figures.

Executives decide how quickly to depreciate assets and how large the allowance for doubtful accounts should be (an estimate of how much customer credit is not likely to be repaid). They may also try to renegotiate terms with their suppliers to delay paying their bills, or try to recognize unearned revenue more quickly than would be considered appropriate.  In the long-run these measures are not sustainable because accruals and deferrals are mean-reverting.

For example, if a large portion of unearned revenue is recognized as earnings today then there will be less revenue recognition remaining for the future.  Likewise delaying bill payments today means that the company will show higher expenditures in the future.

When earnings are manipulated in these ways, then they are not representative of the company’s true earning power and are not repeatable.  Research shows that companies with lower levels of accruals and deferrals have more persistent earnings.  Moreover, “Earnings increases that are accompanied by high accruals, suggesting low-quality earnings, are associated with poor future [stock] returns [1].”

To monitor a company’s accruals, Scott Richardson of Barclays and Irem Tuna at London Business School developed the balance sheet aggregate accruals ratio and the cash aggregate accruals ratio [2].

These ratios can be used to view changes in a company’s accruals level over time and to make company-to-company comparisons.  Historical averages and cross-industry comparisons will help you determine what an appropriate level is.

Note that the balance sheet aggregate accruals ratio and cash aggregate accruals ratio will not perfectly match because of noncash transactions and other classification differences, but the two are highly correlated (0.80)^2.  Both should be used when making time-series and company comparisons.

Balance Sheet and Cash Aggregate Accrual Ratio

First calculate Net Operating Assets:


Next, subtract last period’s NOA from the current NOA figure to arrive at Balance Sheet Aggregate Accruals.

The Balance Sheet Aggregate Accruals Ratio is determined by dividing that number by the average accruals.

The procedure is similar when calculating Cash Flow Aggregate Accruals, as shown below.

Red Flags to Heed

Remember, a jump in earnings accompanied by a jump in the accruals ratio should raise a red flag; so too should a higher than industry-average growth rate with a higher than industry-average accruals ratio.

So, the next time you are looking at a stock then be sure to incorporate these ratios into your analysis.  Doing so may just prevent you from being caught on your heels the next time a company admits to having some skeletons in its closet.  Hopefully, you will have seen the signs and exited sooner than the general public.

About the Author

James DeMasi first became interested in the stock market at the age of thirteen and has pursued it as his career ever since.  In that time he has worked as an investment consultant at EnnisKnupp, where his clients included some of the largest public pension funds in the United States, served a brief stint as a Wall Street trader, and is currently the founder of Seraphin Group LLC, a value-oriented Registered Investment Advisor.

Follow James on Twitter @SeraphinGroup, on Facebook as well as Seraphin Group LLC.

References

[1] Chan, Konan, Louis K. C. Chan, Narsimhan Jegadeesh, and Josef Lakonishok. “Earnings Quality and Stock Returns.” Journal of Business 79, 3 (May 2006): 1041-82. Retrieved from http://www.nber.org/papers/w8308

[2] CFA Institute. Level II Financial Reporting and Analysis. 5th. 2. CFA Institute, 2011. Print.

Posted in Guest Posts, Valuation Methods | 2 Comments »

How to Perform an Asset Reproduction Value Analysis

December 5th, 2011 by Jae Jun

Written by

Jae Jun

How to Value Stocks Series

For other posts in the series, follow the links below.

Getting Back to Basics: Asset Valuation

There is a new blog (csinvesting) that has intense educational valuation material available. Pages and pages of notes and valuation based on Greenwald’s and Greenblatt’s classes from Colombia University.

The valuation method focused on the site is based on asset reproduction value and earnings power value (EPV). The overall idea is simple, but to analyze, value and understand the valuation method and apply it to your company requires digging and hard work.

I was surprised by how much I had missed in my EPV valuations after reading a few of the case studies, and it has inspired me to take a more systematic approach and to re-learn everything. With that in mind, I’ll be using the approach from csinvesting to go through NPK’s asset valuation, which is the first company that I wanted to study from the best small companies list.

I’ve made the math easier by incorporating EPV into my stock valuation tools, but for those that do not know in detail how EPV works, here is a detailed step by step EPV of Microsoft.

From Book Value to Reproduction Value

First step in a Graham and Dodd valuation is to calculate the asset value of a company. Rather than making this the first and only step, you need to go further to check the reliability of the data and strategic direction of the company and industry to determine what the actual cost of the balance sheet really is.

A company could have two vastly different valuations based on the accounting method used. You can see the differences between conservative and aggressive accounting methods.

At the end of the day, GAAP accounting is “theory” and the purpose of the asset valuation is to determine what the actual cost of running the business is. This requires going beyond the balance sheet and diving deeper into the footnotes to make adjustments to find undiscovered value.

Replicate NPK’s Balance Sheet

Book value is simply the assets – liabilities as stated on the balance sheet. This is the value of the of how much it is worth today.

Reproduction value looks at how much it will cost a competitor to purchase the assets required to run a competing company.

As an example, based on book value, machinery and equipment could have been depreciated over 5 years and is now worth $1m on the books compared to the purchase price of $2m.

However, a competitor would have to pay $2m to purchase new equipment instead of $1m.

Thus the balance sheet of NPK will have an increased adjustment to the machinery line item to be $2m instead of $1m.

Confusing? Well let me go through NPK’s 2010 balance sheet.

Balance Sheet Adjustments to Current Assets

Based on the numbers from the 2010 annual report, below is the stated book value versus some slight adjustments to the line items.

As you can see, the difference between the book value and the adjusted values for the current assets are negligible.

Cash and market securities will always be 100%. Cash is what it is, no more, no less. $1 cannot = $2.

You need to add the doubtful reserve to accounts receivables. A competitor will not have the luxury of being able to perform at the same level without a doubtful account for A/R.

Inventory is increased by $4.2 million because NPK uses the LIFO inventory method. Restating it in terms of FIFO results in an increase of $4.2m. The way to look for this is to do a search on the 10-K for “LIFO” or “FIFO” reserves and see what it says in the notes.

Deferred taxes. NPK expects to receive $6.3m from overpaying taxes. This 2010 report was released at the end of its fiscal year so at the time this report came out, I’m guessing that it was one quarter away from receiving the deferred taxes.

$1.6m is one quarter worth of deferred taxes ($6.3m/4) and my rough estimate of the present value of the deferred tax.

No adjustments to other current assets.

Balance Sheet Adjustments to PP&E

Basic PP&E is $58m but after reading up on the company a little, I’m convinced that it will be worth much more. NPK is very easy to analyze because they lay all their stated and adjusted values for you.

In this case, the 2010 value of PP&E was $58m, however, $49m was deducted for accumulated depreciation. Add that back in to get the adjusted $107m.

Rather than skip ahead, here is a deeper look at PP&E.

NPK is over 100 years old. This means that they have assets that have been written off to zero, when in fact, a competitor will pay to own that same asset.

NPK owns land and buildings and uses a straight line depreciation method giving 15-40 years of depreciation to buildings. I would be willing to bet that their buildings are worth much more than what is stated on the books after depreciation considering their long operating history.

To get better value ranges of the buildings, you could get somebody to appraise the property/surrounding comparable properties and use it as the adjusted value.

Or do searches online to get estimates. All this takes time though.

If NPK was a much larger company, with many operating units, you should break it down further.

E.g. NPK has a facility where 314,000 sq ft is used for industrial purposes, and 140,000 sq ft is used for offices.

Doing a search shows that the industrial buildings are much cheaper compared to offices. In Wisconsin, where this building is located, industrial buildings go for a range of $2 – $5 per sq ft compared to $7 – $12 per sq ft for office buildings.

So you could do something like 314,000 x $5 + 140,000 x $12 = $3.25m for this facility.

Repeat for other buildings and land values.

Machinery and equipment in NPK’s business is specialized. In a liquidation scenario, highly specialized equipment will be discounted heavily as the number of buyers are limited and could already have such a machine making the equipment worth much less than say a photocopier that everyone wants.

But as an ongoing asset, NPK’s equipment is expensive and requires a competitor to pay the full price.

Again, NPK makes it easier by stating the actual cost of the equipment.

Balance Sheet Adjustments to Goodwill

Adjusting for goodwill is trickier. This is where you have to understand the business and industry.

Goodwill means that a company has overpaid for another company but what that additional cost doesn’t specify is the relationship with customers, the brand image, network effect, patents and other skills that can’t be valued on the balance sheet.

It’s up to you to think things through and add back those special cases.

For NPK, R&D is negligible but it does have important patents for its housewares/small appliance business. The housewares segment make up 30% of revenue and its patents protect that revenue to a certain degree. I’ve assigned a value of $2m for its patents. A tiny amount compared to the revenue.

Since NPK sells its products through distributors, and there are no long term contracts set with any of their buyers, I don’t see any value here. Anyone could copy their distribution channel.

The Absorbent Segment requires in-depth know how and special training to operate the machines and to maintain quality. It costs money to train all those people to guarantee product quality meets specifications and orders.

$2m in value for this skill is a small yet fair amount.

Final Adjusted Asset Side of Balance Sheet

The total adjusted asset side of the balance sheet is shown below.


You may have noticed by now that performing this exercise forces you to think about all aspects of the business. You start with a broad view and then with each line item, you try to break it up into smaller pieces. This is how you find hidden value that most investors would miss.

At first the process is quite long, but once you get used to it, it will become quicker. Practice makes perfect.

Adjusting the Liabilities

The accounting/mathematical definition of the balance sheet is

Assets = Liabilities + Equity

but the financial/business definition of a balance sheet is

Liabilities and Equity are the sources of funds that support the assets.

Rather than paying the asset reproduction value you must know how much money you have to pay out of pocket to acquire or replicate the assets. This means subtracting certain liabilities. Not total liabilities.

The reason for not subtracting total liabilities is because total liabilities includes what Bruce Greenwald calls spontaneous and circumstantial liabilities.

Spontaneous Liabilities or Non Interest Bearing Debt

Investopedia says:

Liabilities of a company that are accumulated automatically as a result of the firm’s day-to-day business. Spontaneous liabilities can be tied to changes in sales - such as the cost of goods sold and accounts payable.  These liabilities can also be “fixed”, as seen with regular payments on long-term debt.

Other examples include accounts payable, deferred taxes and accrued expenses.

These liabilities arising from day to day operations are not required by a new entrant, thus this amount should be removed from the reproduction value.

Circumstantial Liabilities

This liability is as the name implies; liabilities incurred by circumstances in the past.

Such circumstances may include

  • paying penalties for insider trading
  • lawsuits from former employees
  • inventory catching on fire
  • etc

These types of liabilities must be subtracted as it adds no value to assets. A competitor is not required to pay for these circumstances to start a competing business.

Subtract Cash not Required to Run the Business

The final step to calculate the reproduction value is to subtract cash that is not required in the business because you want to value the assets based on how much a competitor would pay for the same things today.

It takes about 1% of sales to run 1 year of operations so the remaining 99% of cash can be removed.

Final Net Reproduction Value of NPK in 2010

Net Reproduction Value = Adjusted Asset Value – Spontaneous & Circumstantial Liabilities – Cash not Required in Business

$669.2m – $66.7m (spontaneous) – $4.5m (deferred tax liability) – $4.8m (1% of sales) = $593.2m

NPK Asset reproduction value is $593.2m vs  Book value of $426.5m.

Putting it Together

Dec 31, 2010 at the time of the annual report; $130 stock price with 6.86m shares outstanding.

  • Market valuation of equity was $889m
  • Enterprise value is $955.7m

Both book value and net reproduction value makes up about half the market value which means that the stock price is well supported by the assets. The remaining half of the stock price is made up of growth expectations, which you can also consider as the “speculative” value.

You know what you are paying for with the $130 price tag. Whether the remaining half of the stock price can be attributed to a strong competitive advantage is another discussion.

I was lucky that NPK is a very straight forward example. The company is very shareholder friendly, and it shows in the way they present the data in the financial statements.

Other companies will be more difficult because the required information may be buried deep in the report.

If you try the same exercise for a company like GRPN, you will see that the adjusted balance sheet will be considerably lower than what is stated on the books.

Then compare the net reproduction value to the market cap and enterprise value to understand what the market is expecting from the company.

Additional Resources

Earnings Power Value EPV and Book Review

Bruce GreenWald’s Earnings Power Value EPV Lecture Slides

Valuing Liz Claiborne

Sealed Air Valuation Case Study

Posted in Valuation Methods | 2 Comments »

Value Stocks Like a Pro. The Absolute PE Model.

June 27th, 2011 by Jae Jun

Jae Jun

How to value stocks series

For other posts in the series, follow the links below.

It’s been a long time coming but I’m finally getting around to reverse engineering the absolute PE valuation model that Vitaliy Katsenelson created and explains in his book Active Value Investing.

If you haven’t read the book, check out my review of Active Value Investing. If you want to value stocks the way Katsenelson does, it certainly is worth the read.

From this point onward, you may need to slow down your reading as you process the methodology and think through how it all comes together. Nothing is new here. All of the information is directly from the book.

Vitaliy Katsenelson’s Absolute P/E Model

This model derives the intrinsic value of the stock based on the following five conditions.

  1. Earnings growth rate
  2. Dividend yield
  3. Business risk
  4. Financial risk
  5. and earnings visibility
Like all valuation models, there is some subjectivity involved. In this case, you are required to grasp an understanding of the business to identify the level of risk involved.

Core Principles of the Absolute P/E Model

No Growth PE

Part of the reason why I created the no growth PE screen backtest was for the purpose of this valuation method. I needed to know whether my conservative nature of using a PE of 7 for no growth was factually correct. My results show that a PE range of 7 to 8.5 is perfectly acceptable so you are free to use whatever suits you.

Graham used 8.5 in his Ben Graham formula, and Katsenelson uses a PE of 8 in the book. I’m going to stick with my PE of 7 because if you flip the PE over, I get an earnings yield of 14.2% compared to 11.8% and 12.5% for Graham and Katsenelson respectively.

With the small caps I analyze, demanding an earnings yield of 14.2% is better than 11.8% wouldn’t you say?

However, if I were to analyze large blue chips such as MSFT, I would be content to adjust the PE to 8.5.

Earnings Growth and PE Relationship

Logically, higher growth rates leads to a higher PE. However, this model does not have a linear relationship. The absolute PE model is set up so that for every percentage of earnings growth from 0% to 16%, the PE increases by 0.65 points instead of 1 point.

If the growth rate reaches a certain level, in this case 17%, the PE value is increased by 0.5 points. You have witnessed many times that the higher the growth rate, the greater the fall from the top.

Earnings growth projections are made for five years or longer and with higher earnings visibility, a higher PE factor is assigned.

Think of it this way, the earnings visibility of Coca Cola (NYSE:KO) or even Microsoft (NASDAQ:MSFT) is clearer than Salesforce (NYSE:CRM) or a cyclical company such as Caterpillar (NYSE:CAT).

Value of Dividends

Dividends are tangible to the investor whereas earnings is not. Dividends provide you with a hard return whereas you may never get to see earnings. So in contrast to the non linear relationship between earnings growth and PE as shown in the table above, dividend yield and PE will have a linear relationship as shown in the table on the right side.

Every dividend yield percentage receives an equivalent PE point. If the dividend yield is below 1%, use a PE factor of 0.5.

PE Factors for Business & Financial Risk and Earnings Visibility

This part is the most subjective of the valuation model as it requires you to come up with a single number to summarize the risks and earnings visibility.

For business risk, you may want to consider the industry the company is in, the products, the life cycle, concentration of products and customers, environmental risks  and anything else related to the operations of the business.

The level of financial risk can be determined by examining the capital structure of the business as well as the strength of the cash flow in relation to debt and interest payments.

Earnings visibility is analyzed in  much the same way.

Below are the risk points to use in the model.

  • For an average company, you will want to assign a value of 1.
  • For a market leader, select a number less than 1. If you believe a market leader deserves a 10% premium, then use a value of 0.9. If a 15% premium is deserved, then 0.85 is the number to use.
  • For a market lagger, select a number greater than 1. Poor companies should be discounted. A 20% discount requirement means a value of 1.2 will be used.

Qualitative Aspects of the Absolute PE Value Model

Before moving onto examples of how this model is used, a couple of points made in the book should be considered.

Put a ceiling on growth

Based on the business risk, financial risk and earnings visibility, additional PE points are added to the basic PE.

For example if a company is expected to have 10% earnings growth with 0% dividend yield, according to the table above, I would assign it a PE of 13.5.

Now, depending on how good the company is, additional PE points are added based on business risk, financial risk and earnings visibility.

Katsenelson writes that he limits the premium to the basic PE to be no more than 30%. In other words, if the basic PE is 13.5, despite how good the company is, the final adjusted PE won’t be more than 17.55 (13.5 x 1.3=17.55). If the basic PE is 10, then the ceiling will be limited to PE 13.

Inflation and interest rates

The model assumes that inflation and interest rates are average and not expected to increase or decrease to dramatic new levels.

In the current environment, interest rates are low with possibility of inflation. If inflation and interest rates are expected to rise, then the zero growth PE should be adjusted down and vice versa. There is a caution against using current interest rates without considering the long term direction.

This is the PE Model Formula

You now have the PE table to determine the basic PE as well as the understanding of the risk points for business, financial risk and earnings visibility.

Now let’s put it to use.

The formula to calculate the intrinsic value PE is the following:

Fair Value PE = Basic PE x [1 + (1 - Business Risk)] x [1 + (1 - Financial Risk)] x [1 + (1 - Earnings Visibility)]

Testing out the Valuation on 3 Stocks: WMT, TGT & SVU

Let’s use Wal-Mart (NYSE:WMT) as an example.

Wal-Mart is the industry leader in retailing. Strong balance sheet, huge competitive advantage capable of swallowing any small competitor. Consistent dividend payouts, FCF cow, stable margins, CROIC of 8% with ROE of 20% makes this one of the best retailers in the world. Debt isn’t an issue as FCF can cover all interest payments. It also makes earnings growth and visibility easier to determine.

Based on the past 5 year median EPS growth, WMT achieved 11% earnings growth which sounds about right. Although WMT is the best of breed, I’ve only given it a 5% premium for the business as retail is still a tough competitive industry to be in.

  • Expected Earnings Growth: 5%
  • Dividend Yield: 2.75%
  • Business Risk: 0.95
  • Financial Risk: 0.95
  • Earnings Visibility: 1.0


As you can see, for a great business such as WMT, the fair value PE is 18.63. Make a note to apply a maximum premium of 30% to the basic PE which means that the final fair value PE should be capped at 21.97. However, since WMT is in the retailing business, I could have put the business risk as just 1.00 not giving it any premium due to the nature of the industry.

According to this calculation WMT is priced attractively with its current PE of 12.33.

How about Target (NYSE:TGT)?

Definitely number two behind Wal-Mart. Margins are solid and consistent, with a sub par CROIC of 3.6% over the past five years. ROE of 17% and no issues with debt of financial risks. Earnings growth however has been a lackluster 5% and likely will be the same.

  • Expected Earnings Growth: 5%
  • Dividend Yield: 2.56%
  • Business Risk: 1.00
  • Financial Risk: 0.95
  • Earnings Visibility: 1.0

Looks to be fairly valued at the moment with TGT trading at a PE of 11.42.

On the other side of the Spectrum is SuperValu (NYSE:SVU).

A company in a turnaround process with fluctuating returns, margins and earnings. Definitely the lagger of this group.

  • Expected Earnings Growth: 8%
  • Dividend Yield: 3.95%
  • Business Risk: 1.10
  • Financial Risk: 1.00
  • Earnings Visibility: 1.10

SVU is much harder to analyze with PE because of the negative EPS. However, if I use the 2011 FCF figure and divide it by shares outstanding to apply Buffett’s “owner earnings” concept, owner earnings comes to $2.67. Multiple this by 13.09 to get a fair value of $35 share price.

Quite a difference to the $8.84 it is trading at now, and I’m sure I made mistakes by just grabbing the FCF figure so I’ll leave it up to you to check.

Summing Up

I don’t focus much on multiples but after using this valuation method a few times, I’m beginning to like it. It’s quick and easy method to value stocks without having to know the current price of the stock.

The model does have subjectivity and the results will end up being only as good as the inputs, but it’s a technique that anyone can learn and apply.

Disclosure: None.

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