Pick the best value stocks with our Stock Ranks, screening and valuation tool. Try the live demo today.
- Reverse Earnings Power Valuation Steps
- Reverse Earnings Power Valuation Example
- 1. Create Your Multiple
- 2. Calculate Excess Cash into a Per Share Price
- 3. & 4. Subtract Excess Cash from Share price & Divide by Multiple
- Reverse Stock Valuation Method #1
- Reverse Stock Valuation Method #2
- 5. Determine an Earnings Growth Rate
- 6. Find How Long it would take to Grow Shares to the Value from (4)
- 7. Determine Using Logic and Rationale the Feasibility
- Think about Market Returns
- What is Old School Value?
Many times, astounding and insightful information comes simply from asking and listening to the people around you.
A question was posed in the value investing forum regarding reverse DCF and how it was performed. I know of a simple way of how to calculate a reverse DCF, which I will discuss in the future, but this method uses both earnings and assets.
Essentially it’s more like a reverse Earnings Power Value (EPV) but definitely worth the time to dissect and analyze for yourself.
The original discussion can be found on our value investing forum but has been edited below for easier reading. I edited my comments in square brackets [ ].
This isn’t light material so take time to go through it and digest it.
As always if you have any questions, simply ask and you will be answered.
Reverse Earnings Power Valuation Steps
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
Reverse Earnings Power Valuation Example
1. Create Your Multiple
One example of how [a reverse stock valuation] could be done is to start by assigning a proper multiple factor to the earnings.
If you find, for example, that the average yield on Long Term AAA Corporate Bonds (30 years) has produced 5.9% on average over whatever time period you’re using, and you also find that the market has produced an average annual return of 7.5% over that same period, then the combination of the risk free return (5.9%) and the opportunity cost (7.5%) may be something you’d be comfortable with using as your multiple.
To turn it into a multiple, simply add the two percentages, divide into 1, then multiply by 100 resulting in a multiple of 7.46.
- = 1/(5.9 + 7.5) x 100 = 7.46
[Jae Jun: the reason for the inverse fraction is that a yield is represented by a %. Earnings yield = E/P which too is a %. So if you have a yield and you flip it, you are getting a multiple.]
There are other ways that may make more or less sense. I use an alternative method which uses a combination of the opportunity cost, described above, a risk premium such as the one above, and the actual interest the company is charged on their debt.
In any event, this example will serve its purpose here.
Multiply the Trailing Twelve Months [TTM] in earnings by our 7.46 factor. We’ll use JNJ as an example. JNJ currently has a TTM EPS of $4.87 per share.
- Multiply it by 7.46 and we now get [a share value of]$36.33 based on earnings, assuming our multiple is correct.
Incidentally, this multiple assumes no growth projections into the future.
2. Calculate Excess Cash into a Per Share Price
Excess Cash = Total Cash & Equivalents – MAX(0, Current Liabilities – Current Assets excluding Cash & Equivalents)
In the case of JNJ, their current assets cover their current liabilities so Excess Cash is equal to the actual cash on hand which is $22.13 billion.
From this, deduct all interest bearing debt (not total liabilities) and we need to dig into the 10-K &/or 10-Q.
For simplicity, we’ll assume that amount is $12.02 billion for JNJ.
- We subtract the $12.02 B from the excess cash and arrive at an asset valuation of $10.11 B which results in $3.68 per share.
[Jae Jun: when Jim talks about “asset valuation” it doesn’t refer to the entire assets of the company. Since we are looking at excess cash, the asset portion is really the excess assets that are not required to run the business.]
- Add $3.68 per share to our earnings valuation of $36.33 to arrive at a total market valuation for a no growth case of $40.01 per share. This price does not include a margin of safety.
The one portion of our valuation that remains constant is the asset portion ($3.68). This number is what it is and doesn’t change.
We now need to find what portion of this amount is represented in the overall valuation.
- We find this by doing ($3.68 / $40.01) x 100 = 9.20%.
Therefore, 9.20% of our valuation must consist of our asset valuation that doesn’t change and 90.80% of our valuation must come from earnings that do change.
Two different approaches can be used now that produce two opposing views but utilizes the same share price.
Both have their flaws yet give interesting information to think about; which is the ultimate goal of the project.
3. & 4. Subtract Excess Cash from Share price & Divide by Multiple
Reverse Stock Valuation Method #1
Currently, JNJ is trading for $61.69 per share, a premium to our valuation.
In order to find what the market is valuing the earnings to be currently, because our original estimate was based on a no-growth formula
- remove the $3.68 per share asset valuation from the current market price and arrive at $58.01 per share.
This means that the current price of $61.69 has $58.01 attributable to earnings.
Skipping back to the multiple we originally came up with (7.46)
- divide that multiple into $58.01 and arrive at $7.78 [=58.01/7.46] per share
This represents what the market currently values their EPS to be worth.
Before you dive into the meat of the content, if you haven’t signed up with your email for our free investment resources, do so.
I’ll immediately send you extra stock ratios notes, checklists, spreadsheets and additional downloads you can succeed with.
Reverse Stock Valuation Method #2
Assuming that the relationship between Earnings and Assets always remains at 9.20%:90.80%, and that relationship could easily be improved on by calculating the various growth of assets and earnings, we can seperate the current $61.69 share price by the two factors.
- Amount attributable to assets is $5.68 [=9.2% x 61.69]
- $56.01 [=90.8% x 61.69] is attributable to the earnings.
Using our 7.46 multiple, this information translates into expected earnings of $7.51 per share
- $7.51 = 56.01/7.46
In method #1, the question becomes:
is the market over inflating the earnings?
In method #2, the quesiton becomes:
is the market over inflating the earnings and the assets?
If the current EPS is $4.87 and the market is valuing that to be $7.78 according to method #1, we need to find a proper earnings power to project how long it would take to arrive at the latter.
5. Determine an Earnings Growth Rate
I’ll present a calculation, disregarding detail for presentation purposes, that will help determine a proper earnings growth rate (earnings power).
We’ll use the last 10 years of data for JNJ.
In 2000, JNJ had a book value of $18.8 Billion. In 2009, their book value grew to $50.6 Bilion. Therefore, they increased their book value in the last 10 years $31.8 B.
This amount represents how much money the company has allocated back into the business (assets above obligations).
There are many variables to consider in deciding this amount – far too detailed for this example.
During the same period, JNJ grew its net income $7.47 B.
- The return on investment therefore is ($7.47 B / $31.8 B) * 100 = 23.49%.
During this period, 2000-2009, JNJ produced aggregate earnings of $90.03 B. Therefore, the rate of reinvestment they produced is the amount of invested capital divided by the aggregate profits they produced
- ($31.8 B / $90.03 B) * 100 = 35.32%.
Multiplying the two numbers we arrived at produces an Earnings Power of 8.30%
- =0.2349 x 0.3532 x 100
To backtest the accuracy, JNJ produced $1.73 per share in earnings for 2000 and $4.45 per share in 2009.
That equals an 11.07% averaged annual growth rate.
- CAGR formula = (4.45/1.73)^(1/9) -1 = 11.07%
Of course for accuracy, its best to go through the earnings to account for non-cash and one time events on the income statement and do accordingly in respect to intangibles and “other items” on the balance statement.
Nonetheless, our 8.30% Earnings Power when compared to the past produces a very reliable assumption for JNJ.
6. Find How Long it would take to Grow Shares to the Value from (4)
With JNJ’s TTM EPS of $4.87, our previous assumptions in regards to value, we’ve found that the market (example #1) has valued JNJ’s earnings at $7.78 per share.
In this scenario, assuming our 8.30% growth factor, it would take 5.88 years for JNJ to produce those earnings.
7. Determine Using Logic and Rationale the Feasibility
These scenarios weigh heavily on how one arrives at his growth factor.
Each individual has his own way of doing that and when in doubt, it’s best to be conservative. I’ve found that a good rule of thumb is to start with the obvious risk free rate. That, in my opinion, is what it is and shouldn’t be tinkered with.
Currently, 30 year AAA Bonds yield 4.68%. Historically, they’ve produced 5.9%. Therefore, the beginning structure to your multiple will always start off with either the current rate of 4.68% or the average of 5.9% which produces a multiple of 21.37 [=1/0.0468] and 16.95 [=1/0.059] respectively.
Then, it would be wise to judge this multiple against the current PE of the market, say the S&P 500, as well as the historical average of the market.
Currently it’s around 21.5 and historically it’s been 16.6.
If your starting multiple, thus far, is greater or equal to the current PE of the market – I would advise caution that your multiple is too high. Also, if it is significantly higher than the historical average, I would caution that it “could be” too high as well.
Think about Market Returns
In closing, the S&P 500 currently has a multiple of approximately 21.5.
1/21.5 = 4.65%. Essentially, the market is saying it expects to produce a 4.65% annual return. 30 Year AAA Corporate Bonds are 4.68% (last I checked). There’s some information to contemplate in that.
All the best,
What is Old School Value?
Old School Value is a suite of value investing tools designed to fatten your portfolio by identifying what stocks to buy and sell.
It is a stock grader, value screener, and valuation tools for the busy investor designed to help you pick stocks 4x faster.
Check out the live preview of AMZN, MSFT, BAC, AAPL and FB.