How to calculate Return on Equity?

[Snoopy]

Snoopy I guess the next thing to work out is the intrinsic value.

The Graham formula proposes to calculate a company’s intrinsic value V* as:
<snip>

To apply this approach to a buy-sell decision, each company’s relative Graham value (RGV) can be determined by dividing the stock’s intrinsic value V* by its current price P:

An RGV of less than one indicates an overvalued stock and should not be bought, while an RGV of greater than one indicates an undervalued stock and should be bought.

I am not sure how accurate this method is, but I guess it gives a relative valuation that one can compare against the share price and ROE.

I want to say something on the Ben Graham formula , even though it is tangential to the topic of this thread, before I move on.

If you are looking for some share valuation formula where you can stick in some values, crank the handle and get out an 'accurate value' at the other end then I think you will end up disappointed. Any formula based on historical inputs will only give a meaningful answer if those historical numbers you are feeding into it have meaning today and in the future.

In the case of Telecom the industry rules have changed (thanks to the government unbundling announcements). We now have the retail/wholesale 'split' to deal with. Furthermore the way Telecom operates their business model units has changed as well. Telecom have 'repackaged' their businesses into customer focussed 'Consumer' and 'Business' units. The old 'technology packaged' mobile, local service, calling and Broadband/Internet business units are no more (for reporting purposes). Off hand I cannot think of a more radical change for any company I have been a shareholder of, over such a short period of time. Whether the historic Telecom results of even five years ago have any meaning in today's terms is debatable.

Moving to specifics the 'V' value of over 13 you have calculated for FY2007 derives from using an 'eps' figure of $1.58 which includes the one off profit from the Yellow Pages sale. This result while 'accurate' (which means you made no obvious mistakes in the calculation) is also meaningless. That's because the Yellow pages division can only be sold once and the effect of that sale has already been reflected in the share price. (You should have used the adjusted net earnings of $955m instead.) What you have calculated Jackie, is that Telecom is an absolute steal (having an RGV of 3) provided they can sell the Yellow Pages Group again this financial year. A true statement, but one that is of no use to us as investors looking forwards.

Turning to the mechanics of Ben Grahams formula, the core of what Ben is doing is taking 'earnings per share', multplying that number by a predetermined 'Price Earnings Ratio' of 10.1 (calculated by using a typical PE ratio for zero growth, incrementally increased to allow for what real growth the company has demonstrated in the past).

Earnings x Price/Earnings = Price

That is where your valuation (V) share price comes from. Personally I think this formula will underestimate the value of a utility share quite seriously. I think that when earnings from Telecom stabalise (whenever that might be) it should trade in a PE of around 15, given the very strong market position the company has. Grahams formula does not allow for different PEs across different industries.

The formula then tweaks the above result by recognising that valuations are also affected by interest rates. Thus the PE result is 'scaled' by a factor to take this into account by dividing the base timeframe 'long term interest rates' by today's timeframe 'long term interest rates' of comparable quality. If todays long term interest rates are substantially higher than the base case long term interest rates then the value of the PE, and consequently the shares themselves, is proportionately reduced.

The problem we face by using this formula in New Zealand is that it was set up by Graham in the US, for US markets. I notice Jackie that you have replaced the "US base case rate" of 4.4&#37; by

"the average yield of high-grade corporate bonds in 2007= 8.61%".

I do not believe that is a valid substitution, because it is not obviously an historical base case average, like the 4.4 was. However you have divided into that 8.61%

"the current yield on AAA corporate bonds"

That is effectively exactly the same thing. Were you not suspicious when the numbers were virtually identical? Any number divided by itself is one.

So really for 'V' in your spreadsheet you have gone back to Ben's original formula

Price = Earnings x Price/Earnings

or as Ben writes it

Price = Earnings x (8.5+2g)

where g=0.08 (8%)

On the subject of adjusted earnings for Telecom, you may wish to cross reference the work I have already done on the subject.


http://forum.sharechat.co.nz/showthread.php?t=192


SNOOPY