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zyreon
01-12-2007, 11:37 PM
Just been reading "The Dark Side of Valuation" by Damodaran, some interesting thoughts on the PE ratio...

Normally for most people when they see the PE ratio they think price per share divided by earnings per share. While this is correct it is a simplistic way of seeing it and loses all the details of the real factors that comprise the PE ratio and some of the fundamental drivers of value.

For an alternative look at the PE ratio try this:

PE = DPR*(1+G)/(R-G)

DPR = dividend pay out ratio (DPS/EPS) [dividend per share/earnings per share]
G = growth rate
R = required return/cost of equity capital

The above three elements contain the three key drivers of value:
DPR = cash flows
G = growth
R = risk

Thus, while it is intuitively obvious that these three factors should be important - in the above formula you can see how they can be demonstrated to drive value.
Specifically, higher cash flows, higher growth and lower risk lead to a higher PE ratio.



Additional notes:
G = Growth
A simple method of calculating the sustainable growth rate is produced from the ROE and the retention rate i.e. G = ROE*(1-DPR) thus the logic is that any earnings not paid out as dividends will be retained and reinvested at the current ROE (so assumptions apply, but in theory it kinda makes sense).
R = Required return
Usually this is derived from the CAPM i.e. R=Rf+B(Rm-Rf) where Rf = risk free interest rate B = Beta and Rm = market return. Thus the CAPM takes the risk free rate and adds a risk adjusted market risk premium to it - so you can see that the Beta is the proxy for risk in the PE model above.

Lizard
02-12-2007, 09:46 AM
Hi Zyreon,
Your P/E ratio is a valuation tool in terms of determining an appropriate share price rather than a measurement of the actual P/E. Equivalent to using the constant growth dividend discount method - although I think DDM tends to use expected growth in dividends, which does not necessarily match your (sensible) equation.

In my view, these types of equations probably only work well for large companies with a consistent operating history and a stable balance sheet (and therefore representative historical data). Very few NZ companies would fall into that category. In terms of actual use, I would suspect pure use of such an equation (on appropriate stocks) in the current investment climate would direct you towards stocks which had had a very successful run over the past decade and were now approaching a less favourable outlook. These stocks would most likely be the ones to appear cheap, as investors would be selling at below the value indicated by past performance.

It is interesting that the market still clings to P/E as a measure - EV/EBITA, with its incorporation of balance sheet, would seem more sensible as a screening/selection tool. But I have yet to find an easy data source for this.

zyreon
02-12-2007, 10:05 AM
Valuation is about trying to estimate a value based on the future - and I agree this can be easier for more established companies - however when you come up against new technology firms such as those around the dot.com boom the fundamentals are still the same. It just becomes more complicated, it comes down to trying to put together a set of reasonable estimates, and sometimes this produces valuations that are way out of line with the market... and during the dot com boom this meant the market implied variables were simply unrealistic (i.e. you could instead go to the market and get the stats and find implied figures e.g. 100=.20/(X-10%) etc).
You are quite right about it being a multiple derived from the DDM (where price=dividend per share/(R-G)) - I like it because it breaks things down, yet remains relatively simple.
My only concern with using EV/EBITDA is that it is a firm valuation method - which is fine if you're planning an LBO but if you're only looking at it as an equity investor then you need to look at equity valuations instead... however it could be used for selection purposes by identifying potential candidates for LBO/M&A and speculating appropriately...

Lizard
02-12-2007, 12:17 PM
Zyreon,

Here's a few of my thoughts on valuation:


Valuation is useful, but different types of valuation technique serve better with companies at different stages of maturity and in different industries. In developing companies, investment comes first, then revenues are produced, then profits, then dividends. The basis for valuation is something which should be matched to the stage.

Consideration of the balance sheet is essential to any form of valuation - buying "value" alone is likely to direct you into distressed businesses or situations where existing equity is more likely to be diluted. It also misses companies that are positioned to invest in explosive growth.

Valuation should always be forward looking. Seems obvious, but the temptation is to apply formulae which automatically generate a value based on historical data.

Value in itself is not a reason to buy. The primary criteria should more often be "a good business" with consistent management, good ROA, in a rising market sector and with a competitive edge.

Valuation can demonstrate that buying a business with sustainable high levels of earnings growth will mean there is no price too high for a long term holder. This is a valid conclusion - but not always the most profitable thing to do in the short term.

Valuation always needs to be considered in the light of market conditions. Profit margins of greater than 20% rarely last. And high returns on assets make a sector attractive for competition.

Lizard
02-12-2007, 06:56 PM
Um, I hope I haven't killed a very good thread by Zyreon here - I really don't know much about this stuff. Next please. :o

zyreon
02-12-2007, 07:33 PM
heh, been out... Yep good points there.

I think it is a mistake though when people say that you need to look beyond the numbers - because at the end of the day your numbers must actually take into account things like competitive landscape, business life cycle, management quality, and so-on and so-forth. I guess in essence the job of a valuer is to quantify some of these potentially more qualitative factors so that they show through in the valuation. You do need to approach it from many angles and when you have a company where the earnings are negative there may still be plenty of NPV...

Actually I'll post a couple more formulae from the book
PS (price to sales) = [net profit margin x DPR x (1+G)]/(R-G)
PBV (price to book value) = [ROE x DPR x (1+G)]/(R-G)

Obviously you can use the above two multipliers where there is no current positive earnings...

stephen
02-12-2007, 08:44 PM
"EV/EBITA, with its incorporation of balance sheet, would seem more sensible as a screening/selection tool. But I have yet to find an easy data source for this."

That sounds like one of the criteria in the "magic formula" described in the __The Little Book That Beats The Market__.

I am working on a screening tool for the ASX and NZX using these principles. The data IS out there, eg on Yahoo finance - it's just a question of aggregating it, and that's not actually hard to do.

steve fleming
02-12-2007, 09:46 PM
Normally for most people when they see the PE ratio they think price per share divided by earnings per share. While this is correct it is a simplistic

To me, the simplicity is the beauty of the PE ratio - it provides a pretty quick assessment of a company's relative value against its peers/comparable companies, its sector and the market generally, as well as its own historical PE.

While the Damodaran version is probably more accurate, and is great in theory, practically it would be just too much effort to make much use of.

As Lizard rightly pointed out, EV/EBIT or EV/EBITDA is a far more robust capitalisation multiple, and which i find is being used more and more these days (as it should be!) at the expense of PE ratios.

EV/EBIT and EV/EBITDA multiples eliminate distortions between different companies' capital structuring (I), asset utilisation (D&A) and tax positions (T), thus providing a far more accurate estimate of operating earnings for each company - which in turn makes it a better measure for comparable company analysis as you are comparing like against like.

However it requires a bit more work to calculate than a PE - unless you have access to a financial database like Bloomberg or Reuters!



My only concern with using EV/EBITDA is that it is a firm valuation method - which is fine if you're planning an LBO but if you're only looking at it as an equity investor then you need to look at equity valuations instead... however it could be used for selection purposes by identifying potential candidates for LBO/M&A and speculating appropriately...

Zyreon - you can simply deduct debt/surpus cash from the firm valuation/Enterprise value and that gives you the equity valuation / market cap.

steve fleming
06-12-2007, 09:23 PM
Um, I hope I haven't killed a very good thread by Zyreon here

Well you gave it a pretty good punch in the head, Liz...but looks like mine was the killer blow!:)

Snoopy
07-12-2007, 09:22 PM
Just been reading "The Dark Side of Valuation" by Damodaran, some interesting thoughts on the PE ratio...

Normally for most people when they see the PE ratio they think price per share divided by earnings per share. While this is correct it is a simplistic way of seeing it and loses all the details of the real factors that comprise the PE ratio and some of the fundamental drivers of value.

For an alternative look at the PE ratio try this:

PE = DPR*(1+G)/(R-G)

DPR = dividend pay out ratio (DPS/EPS) [dividend per share/earnings per share]
G = growth rate
R = required return/cost of equity capital


If you think in terms of 'per share' then the price earnings ratio, or PE, is simply the current share price divided by the earnings per share.

If you re-express Damodaran's formula in per share terms, I get:

Share Price/EPS = (DPS/EPS)*(1+G)/(R-G)

Take Earnings per share out of the equation on both sides and you get the Damodaran formula for share price:

Share Price = (DPS)*(1+G)/(R-G)

Basically all that formula says is that the share price is the summary of future 'dividend per share' flows, discounted by a risk factor that reflects the difference between the expected ''market return" and the growth potential 'G' shown by the company in terms of ROE applied to the retained earnings.

As you so rightly note Zyreon, a higher growth potential will lead to a higher share price which is exactly what you would expect from such a formula. To me, the formula intuitively 'makes sense'.



Additional notes:
G = Growth
A simple method of calculating the sustainable growth rate is produced from the ROE and the retention rate i.e. G = ROE*(1-DPR) thus the logic is that any earnings not paid out as dividends will be retained and reinvested at the current ROE (so assumptions apply, but in theory it kinda makes sense).
R = Required return
Usually this is derived from the CAPM i.e. R=Rf+B(Rm-Rf) where Rf = risk free interest rate B = Beta and Rm = market return. Thus the CAPM takes the risk free rate and adds a risk adjusted market risk premium to it - so you can see that the Beta is the proxy for risk in the PE model above.


As you rightly note Zyreon, any 'formula of thumb' will only be as good as the 'rules of thumb' behind it. Looking back on this thread it looks like others have used it to 'shoot down' Damodaran's formula and propose their own formulae that are 'better'. I wouldn't want to make any judgement on whether these other formulae are really better or not because I suspect the answer is 'it depends on the circumstances'.

I think you need to be aware though, of in just what circumstances the model you have presented works best, and only use it in those circumstances.

The sustainable growth rate assumption

G = ROE*(1-DPR)

will work best when 'new company equity' (through retained earnings), can be worked just as hard as 'existing company equity'. For that to happen you need the company to be in some kind of long term growth path. That means a company analysed by this formula should not be mature and simply battling for market share as a major player in an existing 'capped marketplace'. I learned my own lesson on this the hard way when I created a mathematical model that assumed constant ROE for Restaurant Brands expansion push into Australia. By doing that I could easily justify buying a tranche of RBD shares at $2 plus. But when reality did not co-incide with theory, the RBD share price responded accordingly!

Finally I am always a little suspicious of any formula that uses 'Beta' or volatility as a proxy for 'risk'. That's because I believe there are far better tools to use to create a low risk portfolio than worrying about various stocks' 'Beta'. In fact I believe that the concept of Beta has basically been discredited by none other than those who created it some thirty plus years ago, as part of the CAPM! Nevertheless even if the exact value of Beta you plug into the Damodaran formula is 'wrong'/'not meaningful', that just means that the share price numbers you pull out of the formula should be treated as being 'flexible' rather than 'gospel'.

A good discussion topic by the way. Hopefully others will come along and add to it.

SNOOPY

Hoop
08-12-2007, 08:00 AM
To me, the simplicity is the beauty of the PE ratio - it provides a pretty quick assessment of a company's relative value against its peers/comparable companies, its sector and the market generally, as well as its own historical PE.

While the Damodaran version is probably more accurate, and is great in theory, practically it would be just too much effort to make much use of.

As Lizard rightly pointed out, EV/EBIT or EV/EBITDA is a far more robust capitalisation multiple, and which i find is being used more and more these days (as it should be!) at the expense of PE ratios.

EV/EBIT and EV/EBITDA multiples eliminate ddifferent types of valuation techniqueistortions between different companies' capital structuring (I), asset utilisation (D&A) and tax positions (T), thus providing a far more accurate estimate of operating earnings for each company - which in turn makes it a better measure for comparable company analysis as you are comparing like against like.

However it requires a bit more work to calculate than a PE - unless you have access to a financial database like Bloomberg or Reuters!



Zyreon - you can simply deduct debt/surpus cash from the firm valuation/Enterprise value and that gives you the equity valuation / market cap.
I have been fiddling around with various PE mutants, in trying to value the target shareprice of rapidly expanding companies. I had a drastic end to a love affair with measuring the EBITDA factor into calculations. I prematurely posted an extremely very simple version onto sharetrader under Rakon before it's shock report and ended up with egg on my face....:o:o

...However it requires a bit more work to calculate than a PE - unless you have access to a financial database like Bloomberg or Reuters!...

oh how true Steve (hindsight).

Liz mentions very good points where.... "different types of valuation technique serve better with companies at different stages of maturity and in different industries".

Interesting site for a look is http://valuepro.net/ .They have an expansion of factors to try and take out the kinks in shareprice valuation... haven't yet had the time to read through it properly and digest it

Snoopy I've just started chewing through your Professor Damodaran's formula, must study it up more fully..thanks


Great thread...keep it up

Lizard
08-12-2007, 12:32 PM
Re Snoopy's points on the P/E formula, I would also say that clearly, if you do the same with the P/S formula, then BOTH are actually going to come up with exactly the same valuation - a valuation which is based entirely on dividends and not on earnings or sales, despite the impression given by talking about P/E and P/S.

Where earnings might come into it is in the "growth" formula which requires an ROE - though I would probably modify ROE, since it will tend to tell you more leveraged companies are going to grow faster. This point is not necessarily true. Growth companies regularly swing between net cash and fully leveraged positions as they develop, so a company with a very high ROE one year is more likely to pay down debt or raise new capital, while a company with cash on the balance sheet might use it to suddenly double earnings.

The very best growth situations are difficult to identify as they are often achieved through issue of new equity at favourable prices to undertake favourable acquisitions. This is where the very best companies will also have an eye to keeping constant forward momentum in their share price, as it is that which enables them to use share-based acquisition or favourable capital raising. These types of situations can be completely missed by most value investing, as the shares often appear fully valued - yet it is that in itself that enables a successful growth-by-acquisition strategy.

The use of the CAPM for required return is not something I would favour particularly either - I'm not certain the data required to come up with a value is readily available and personally, I struggle to believe that beta is really a persistent number for most shares. Seems alot of opportunity for GIGO in that particular part of the formula. I'd think it would make as much sense to just pick a common-sense value.

stephen
08-12-2007, 03:51 PM
I alluded to the "magic formula" from __The Little Book that Beats The Market__.

It comprises two steps.

First, rank companies based on:

Return on capital = EBIT/(Net Working Capital + fixed assets)

Out of those, then rank on:

Earnings yield = EBIT/Enterprise Value

[EV = price + interest bearing debt]

The idea behind using these measures rather than simpler ROE and P/E is to eliminate the effects of gearing, taxation and intangibles.

The book wastes a great many pages with cute stories illustrating the principles, but it does actually present a sound case for the formula.

Lizard
08-12-2007, 04:43 PM
That sounds like an excellent method, Stephen. The first formula should identify companies with the capacity to expand quickly. The second should then pick the best value from those. What it doesn't do is pass any judgement on whether the market itself is over-valued or under-valued by creating a set valuation (and there seems no right nor wrong in that approach).

How do they combine the ranking system to create a single rank? Do they simply take the top 10%-20% from the first formula to rank using the second? Or cross product the rankings? Or some other method?

Also, as it is a stock-selection method rather than a valuation method, do they also have an equivalent method for identifying when to exit a stock?

steve fleming
08-12-2007, 05:53 PM
The major benefit of capitalisation multiples (whether it be P/E, EV/EBITDA or EV/EBIT) is providing an indication of relative value.

In isolation, say a zinc miner on a multiple of 4, or an IT services company on a multiple of 30, tells you very little.

But if you have a zinc miner on a multiple of 4 when the majority of other zinc miners are trading at an average of 10 +, then that, prima facie, is evidence of under value.

The more directly comparable companies in the sector/ sub sector, the more valuable such analysis becomes.

I however realise that in NZ where there are so few companies in each sector, meaningful comparable company analysis is difficult.

Lizard
08-12-2007, 06:10 PM
In isolation, say a zinc miner on a multiple of 4, or an IT services company on a multiple of 30, tells you very little.


It would seem sensible to at least separate out resources, pharma, IT, property, industrials and financials before applying any sort of comparative valuation/stock selection. Also to sort between embryonic, growth and mature stage - and to look for different characteristics accordingly.

Snoopy
08-12-2007, 07:06 PM
I still like using PEG ratios, whilst still fairly simple have proved a reliable source of potential stocks to outperform index and sector.

For those who came in late, a definition.

-------

PEG ratio: Definition

A stock's price/earnings ratio divided by its year-over-year earnings growth rate. In general, the lower the PEG, the better the value, because the investor would be paying less for each unit of earnings growth.

-------

Personally I have a preference for keeping my stock selection criteria as simple as possible. Thus PEG, which is simply the PE ratio divided by the year on year annual growth rate, must have appeal.

I guess the problem arises when you have to ask: "What growth rate to use?"

You could take this years net profit, compare it to last years net profit and use that. But that is only useful if you consider that last years earnings growth trend will continue into this financial year.

An alternative would be to use the coming years forecast earnings and compare those to what was earned this year. The thing I don't like about that is the word 'forecast'. Once you start using a forecast statistic like this you need to consider:

1/ Who made the forecast (please don't say 'management', I prefer 'independent')?
2/ How accurate do you consider the forcast to be?
3/ What is the volatility profile of the prediction?

As an example it is possible that management might open up a new arm of the business and predict great things from it. But it could be that 'market uptake' of the new line is slower than they think or some regulatory hurdle is unexpectedly thrown in their way. The market is often good at pricing in threats like this. But a single statistic, like PEG, is not.

I think judgement is important, even essential, for good investment. But personally I prefer 'one level of judgement only' when selecting an investment. With a forward looking PEG statistic there is already one level of judgement within the statistic itself overlayed with another layer of judgement - your own view on what you should do with the PEG numbers. Because PEG requires two levels of judgement, I don't use it.

There is another reason I don't like PEG, and that is the 'short term focus' (only one year into the future) inherent in the PEG number. I am a long term investor. So whatever happens in any one year I regard as just a single point of noisy data on the way to my investment objectives.

I am a member of Etrade Australia, and I thought that I had used PEG as a screening tool when looking at Australian shares in the past. Logging back into the site today I couldn't find where I had pulled the PEG figures from. Mind you, they have redesigned the Etrade website since I last used that tool. So perhaps that screening facility no longer exists there? I would be interested if any sharetrader who is a member of Etrade could find that facility on the site again for me.

In summary I think PEG is a useful selection tool. But I wouldn't invest on the basis of a favourable PEG ratio. The PEG might provide a useful starting point, but more longer term homework would be required for me to be satisfied.

YMMV.

SNOOPY

stephen
08-12-2007, 07:17 PM
Lizard, the "magic formula" is intended as a stock screening tool for a more or less mechanical strategy. Joel Greenblatt's advice in the book, which is geared at the American market, is to use it to pick 20-30 companies annually, selling the losers just before the tax year ends, selling the winners just after. So the exit strategy is simply that the year is up, time to move on.

However, he also recommends it as a method for identifying candidates for further investigation if you fancy yourself as a stock picker. It's not a valuation tool though.

So this is another variation on O'Shaugnessy's tools from What Works on Wall Street.

The way you apply the two calculations is that you screen all companies using the first tool to identify those that are best at earning on invested capital. Select the top umpty. (He suggests 25% ROA if you use ROA as a proxy for the first formula). Then you rank those using the second tool to find the cheapest ones.

He suggests ROA and PE as proxies for EBIT/NWC and EBIT/EV if the latter figures aren't available. He also warns that companies with a very low PE - say 5 or less - should be discarded as being likely to have either disastrous financials or mis-stated/misanalysed figures.

The book explains his reasoning and lays out the evidence. It's a fun read, and probably in your public library - I know Wellington has a copy, or it will when I return it on Monday ;)

I'm snooping around for sources of free ASX financial data at the moment. I think I've found enough to allow me to aggregate and calculate the preferred formula.

Snoopy
08-12-2007, 09:33 PM
hi Snoop dog, the growth factor can be looked at over say 5 years "past" growth and 1 year or 2 years forward growth combined (together from analysts averages and company if possible) or any combination of data if not for 5 years, much like looking at 5years of positive eps growth (buffett style) but on a % basis.

OK Sectorsurfa. Using the 'traditional' definition of PEG that I copied from 'www.investorwords.com' it looked like the growth used was strictly on a 'one year forwards' basis. That one year figure could be unrepresentative of a share's long term prospects, which was the heart of my concern. If you use a 'seven year average' figure, combining the last five years with a foreacst for the next two, that would alleviate my principal concern. I think we are getting into the realm of a modified PEG here though, which nevertheless might be a good thing.



One thing I did find curious about your paragraph above was you suggested risk in looking forward just 1 year, but stating you are a long term investor on the way to your investment objectives, which are most certainly "forward" looking assumptions, my question is how do you get there then?


You mentioned 'positive eps growth (buffett style)' before so perhaps you are familiar with the share valuing model espoused by his former daughter in law Mary Buffett in her many Buffettology books?

Without going into the maths here, the basic principal is that if you invest in a company that has some kind of very strong franchise concept, then even if the company has a 'bad year' there is a very high chance that the underlying strength of the business will not be affected. Thus while bad years happen and forecasting what might happen 'in any one year' might not be easy, you can be more sure that that same business will still be around and operating strongly in say 8 to 12 years time. When we invest in a business for that length of time we are more interested in the cumulative compounding effect of our investment rather than what happens in any particular year on the way. The theory is that if you select your companies wisely you can be more sure of where they will be in say ten years time, than where they will be 'next year' or the year after that. Having greater certainty about the ten year timeframe than a one year timeframe is something that only applies to a few companies, it is certainly not the norm. But if you only invest in companies that have that kind of profile, as Buffett does, then investing on a ten year timeframe can be just about the lowest risk kind of investment out there.

SNOOPY

Snoopy
09-12-2007, 07:35 PM
I alluded to the "magic formula" from __The Little Book that Beats The Market__.

It comprises two steps.

First, rank companies based on:

Return on capital = EBIT/(Net Working Capital + fixed assets)

The idea behind using these measures rather than simpler ROE is to eliminate the effects of gearing, taxation and intangibles.


I might have to get hold of that little book Stephen.

Your 'Return on Capital' looks more analagous to the cruder measure of ROA (Return on Assets) than the equally crude ROE (Return on Shareholders Equity).

To some extent the problems caused by the writing off of intangibles, like amortization, giving the impression of a much lower cashflow than actually occurs have been 'fixed' by the new international accounting rules. The new rules mean that intangibles as a result of an acquisition are no longer amortized but are instead subject to an annual impairment test. In most years that means no amortization in the traditional sense.

Also as part of the new international accounting rules 'software' is deemed an intangible that is then amortized. I presume you would still continue to amortize that (?)

I agree that using ROE can cause a company that has a very high level of debt to appear to be a star performer, whereas using a proxy for ROA will strip from the ranks of the apparent top performers those companies that have loaded themselves up with debt to make themselves look good. IMO this is a good reason not to use ROE *on its own* as a stock selection filter. However, I do use ROE in preference to ROA, because ROA does not allow a good cross sector comparison measure between financial shares and other shares.

I am also curious as to why you would seek to eliminate the effects of gearing and taxation. If I buy shares a company,that means I buy in 'warts and all'. The shares I buy are inherently geared at exactly the same level as the whole company is. Likewise I pay my tax on the investment through the company paying tax. As a shareholder I cannot get out of paying my share of tax because the company has already paid it for me.

In a nutshell my question is this. Why spend time analysing your investment by financially transforming the results of the company into what they would be if the company had no borrowings and no tax, when the reality is all companies do have to pay interest on their borrowings and do have to pay tax?

SNOOPY

winner69
09-12-2007, 07:59 PM
For whats itworth I don't worry that much about ROA or ROE but see ROIC (return on invested capital) as more meaningful

ROIC = Operating Profit / (Equity + Debt) expressed as a %age.

Academics are more complicated but Operating Profit can be expressed as EBIT - Notional Tax (at company tax rate X EBIT)

If ROIC is greater than the company's cost of capital it is adding economic value / less it it is destroying value

This way one is getting a real return on all the capital invested - whether it comes from shareholders or bankers

Snoopy
09-12-2007, 08:16 PM
I alluded to the "magic formula" from __The Little Book that Beats The Market__.

It comprises two steps.

First, <snip>

then rank on:

Earnings yield = EBIT/Enterprise Value

[EV = price + interest bearing debt]

The idea behind using these measures rather than simpler P/E is to eliminate the effects of gearing, taxation and intangibles.


From "www.investorwords.com", another Definition

--------

enterprise value

A measure of what the market believes a company's ongoing operations are worth. Enterprise value is equal to (company's market capitalization - cash and cash equivalents + preferred stock + debt). The number is of importance both to individual investors and potential acquirers considering a takeover attempt.

---------

'earnings yield' is, more crudely than you put it, E/P rather than P/E. But I take your point that the comparison is valid provided we all remember that a high E/P is equivalent to a low P/E.

I understand why the alternative 'earnings yield'

Earnings yield = EBIT/[market capitalisation + interest bearing debt]

is important if you want to take over a company. After all, the return you will get on your investment will be maximised if you:

1/ buy all of the shares
2/ AND pay off any existing company debt

But why should your 'Earnings Yield' be of concern to small shareholders? If we buy shares in a company, we cannot force the company to pay off any debt. We cannot force the company to pay less tax either.

So why not just use E/P?, or (Net Profit/Market Capitalisation)

Both my 'E/P' and your 'Earnings Yield' take debt into account. The only difference is that I take the annual impost of the debt, the interest payable, off the top line hence reducing E/P accordingly. You put the total amount of debt in the bottom line and that reduces your 'Earnings Yield' accordingly.

I take tax paid into account using E/P. You do not using your 'Earnings Yield'. But my taking tax into account is not going to change the ranking of shares we compare, because the tax payable is a fixed proportion of any gross income. Thus taking the same proportion off a comparative list of gross incomes will not change any rankings list one bit.

Perhaps I have missed something. But right now I can't conceive of any circumstance when ranking companies by my E/P (or P/E) will select different shares than you ranking the same companies by 'Earnings Yield' EBIT/[market capitalisation + interest bearing debt]. Am I missing something?

SNOOPY

stephen
09-12-2007, 08:37 PM
Snoopy, as I said earlier, why not read the book, which is easily obtainable?

But briefly, my understanding is:

- comparing things without the effect of tax prevents us from accidentally including companies which are carrying forward past tax losses. (Don't forget this is a screening tool, based purely on last years figures, so it's nice to make it a little more discriminating).
- the idea behind removing gearing effects is to see how well the company can use a dollar, no matter how obtained.
- I quote here: "Enterprise value was used instead of merely the __price__ of equity because enterprise value takes into account both the price paid for an equity stake in a business as well as the debt financing used by a company to help generate operating earnings... [big snip] ... in other words, P/E is greatly influenced by changes in debt levels and tax rates, while EBIT/EV is not."

Re EV, the book doesn't say this, but I would have said the small investor should look at EV, because while I can't take over a company, I will likely enjoy a substantial benefit if a bigger investor decides to. As a value investor, relying on other people to reprice an underpriced asset, this is a critical figure for for those other people.

Personally, I don't think there's going to be a huge discrepancy between the selections produced by screening with the "magic formula" and, say, using ROA and PE as screens. But I'm interested to get some ASX data for the All Ords and see for myself.

I'm also thinking that the NZX is too small for a broad screening strategy to work that well.

steve fleming
09-12-2007, 09:36 PM
I understand why the alternative 'earnings yield'

Earnings yield = EBIT/[market capitalisation + interest bearing debt]

is important if you want to take over a company. After all, the return you will get on your investment will be maximised if you:

1/ buy all of the shares
2/ AND pay off any existing company debt


SNOOPY


Snoopy, maybe you are getting a bit confused here.

A takeover valuation is VERY different from an Enterprise value.

A takeover valuation incorporates such things as premium for control and the impact of cost savings and synergies etc - all of which are definitely not reflected in the Enterprise value.

Very simply, SURPLUS ASSETS + ENTERPRISE VALUE = DEBT + EQUITY VALUE.

You can calculate the equity value from an Enterprise value and vice versa.

In practice you will find the EV/EBIT & EV/EBITDA approach used in assesing value far more often than the P/E approach, for the reasons Stephen outlined.

_Michael
10-12-2007, 08:20 PM
Steve

With regards to free financial data on ASX stocks - check out the AFR Smart Investor website - they update an excel spreadsheet weekly with every stock on the ASX it includes quite a lot of data including book value, p/e, etc and you can download it and add in your own formulas calculations as required. Its a great tool for initial screening when looking for value stocks in particular. It also has sector / industry so you can make you own version just filter out your unwanted sectors.

cheers
Michael

steve fleming
10-12-2007, 09:30 PM
Steve

With regards to free financial data on ASX stocks - check out the AFR Smart Investor website - they update an excel spreadsheet weekly with every stock on the ASX it includes quite a lot of data including book value, p/e, etc and you can download it and add in your own formulas calculations as required. Its a great tool for initial screening when looking for value stocks in particular. It also has sector / industry so you can make you own version just filter out your unwanted sectors.

cheers
Michael

Thats a great tool

http://www.afrsmartinvestor.com.au/tables.aspx

cheers

OldRider
11-12-2007, 06:54 AM
Michael:

A great site. The CSV format of so much information will allow quick comparisons,
something that has been time consuming previously.

Mythanks, I thought I had a fair knowlege of ASX internet sites, but this one had escaped me completely.

steve fleming
11-12-2007, 01:23 PM
Steve

With regards to free financial data on ASX stocks - check out the AFR Smart Investor website - they update an excel spreadsheet weekly with every stock on the ASX it includes quite a lot of data including book value, p/e, etc and you can download it and add in your own formulas calculations as required. Its a great tool for initial screening when looking for value stocks in particular. It also has sector / industry so you can make you own version just filter out your unwanted sectors.

cheers
Michael

BTW

_Michael = Flying Goat???

or am i way off the mark?

Snoopy
11-12-2007, 05:08 PM
Briefly, my understanding is:

- comparing things without the effect of tax prevents us from accidentally including companies which are carrying forward past tax losses. (Don't forget this is a screening tool, based purely on last years figures, so it's nice to make it a little more discriminating).


Ah very good point Stephen. Last time I bought into a company with tax losses it was so long ago that I can't remember what it was! You tend to forget about shares that are a long way off your own 'radar screen of comfort'.

Nevertheless declaring a dividend when you have tax losses is 'bad' for the shareholder in the sense that the shareholder still has to pay tax even though the dividend paying company doesn't. So by my thinking, the amount of tax the company has to pay (or not) *is* relevant to the small shareholder (carried forward tax losses being a bad thing). So taxes losses 'on the books' should be considered.

Often tax losses *are* important over many years (not just 'last year') because the situation of a large one off loss that takes many years to recover from is not that unusual in the world of commerce.



- the idea behind removing gearing effects is to see how well the company can use a dollar, no matter how obtained.
- I quote here: "Enterprise value was used instead of merely the __price__ of equity because enterprise value takes into account both the price paid for an equity stake in a business as well as the debt financing used by a company to help generate operating earnings... [big snip] ... in other words, P/E is greatly influenced by changes in debt levels and tax rates, while EBIT/EV is not."


Yes I see what you mean, although this is really another version of the ROE verses ROA argument.

I think there is a natural tendency to regard debt within a company we invest in as 'bad'. I actually regard company debt as good if the company is geared up enough to keep predators at bay. That means the company executives can concentrate on what they should be doing: running the business instead of always fending off offers from suitors.



Re EV, the book doesn't say this, but I would have said the small investor should look at EV, because while I can't take over a company, I will likely enjoy a substantial benefit if a bigger investor decides to. As a value investor, relying on other people to reprice an underpriced asset, this is a critical figure for for those other people.


Yes you have a point there, although I still regard with some contempt the investor who has no vision of their own and regards 'selling out' to someone bigger as the only way to get rich. I would never invest in a share solely because I think it *might* be taken over. As it happens I always seem to be fending off takeover offers. But that is because the suitors saw the same fundamental value in the company that I did, not because I bought 'hopeing' to be bought out. Personally I feel being 'bought out' is rather annoying because it forces me to do a whole lot more homework before I decide when I should reinvest the money

SNOOPY

_Michael
11-12-2007, 05:48 PM
Hi Steve

Yep - my username was FG but when the new site came online i could not get in under my old sign in and no longer had my original woosh email address so had to create a new one...!

steve fleming
11-12-2007, 08:00 PM
Hi Steve

Yep - my username was FG but when the new site came online i could not get in under my old sign in and no longer had my original woosh email address so had to create a new one...!


cool....thought so.

Good to see you back...well done on ISS!

Snoopy
11-12-2007, 10:44 PM
If you use a 'seven year average' figure, combining the last five years with a foreacst for the next two, that would alleviate my principal concern. I think we are getting into the realm of a modified PEG here though, which nevertheless might be a good thing.

Yes, modified PEG, true, I was suggesting that as I am familiar with your "buffetology" from other sites and the value screen, so perhaps I was thinking of using the 'normal' PEG of 1 years forward earning projections with the 5 years of eps growth (1 down year allowed) to find a more stable trend. I am now thinking that is a very useful extension of that particular screen


You are referring to the focus investment group on the other channel?

What I use there is a 'growth model' where the rate of growth is determined by the 'year start' total of retained earnings each year, multiplied by a multi-year average 'ROE', derived for each particular share I am looking at. This is really just a roundabout way of doing what you are doing with your multi-year growth PEG model SectorSurfa. But while I am:

1/ fiddling about taking retained earnings from one year,
2/ adding those to the 'start of year' existing shareholders equity to get
3/ the start of next year shareholders equity, THEN
4/ multiplying the total by my long term average calculated ROE to get my annual growth,

you have short circuited the whole process.

You have taken the earnings from one year, divided it by the earnings from the previous year and worked out your 'growth factor' straight out. That is a much quicker and tidier way to do what I did. Well done!

There are one or two disadvantages to doing things your way I can think of with 'multiyear PEG' though Sectorsurfa.

While it may be true that over the long run, the earnings growth of a company approximates the historical long term earnings growth average, that is *not* the same thing as saying that for one particular year you choose, the earnings growth then will be near average. IOW by using your method over successive years, the sum of the observed growth will converge to the average growth But that doesn't stop the growth rate *in one particular year* oscillating wildly from the average.

The other problem I see is when you want to model out into the future two or three years of rapid growth followed by some years slower growth or vica versa. With your method you are stuck with one 'average' growth rate.



the basic principal is that if you invest in a company that has some kind of very strong franchise concept, then even if the company has a 'bad year' there is a very high chance that the underlying strength of the business will not be affected. Thus while
1/ bad years happen and forecasting what might happen 'in any one year' might not be easy, you can be more sure that that same business will still be around and operating strongly in say 8 to 12 years time.

addressing that particular line - would that only represent the statistical difference between franchise businesses and other businesses startup/ ongoing success, both of which have failure rates. I guess I was getting at the basic principal of still estimating/guessing, when your LT timeframes are that far out (ie 8-10 yrs), just as you have mentioned before about high PE stocks being somewhat dangerous if they are based on high forward projections and expectations. (see Frucor from early days and franchises like Georgie Pie and Burger King in NZ) SS

Possibly I was a little tunnel visioned when I mentioned the term 'franchise' in my explanation.

I was trying to capture Buffett's idea of looking for a business that is surrounded by a 'moat of competance' that is hard to copy - then setting yourself up as the toll bridge operator. A well honed franchise concept is one kind of 'toll bridge' - look how hard it has been for other fast food chicken sellers to get anywhere near KFC. But equally 'toll bridge like' are the natural toll bridges of the 21st century - international airports - or the collection of big box building sites that are 'The Warehouse' taking over prime real estate and forcing new competitors into less desirable locations.

Going up against toll bridge operations like this is not a statistical 'battle it out in the warzone' market fight. A few crack commandoes will not make the difference between winning and losing. The 'toll bridge' businesses have a near unbeatable strategic advantage over any business concept you might wheel out against them. In the battlefield analogy, the new competitors crack commandoes are forced through a narrow neck of land where evening moderately competant defending riflemen can lie in wait to pick off the invading heroes. Short term you might have some wins, but long term the game is stacked against you.

The reason I can make business projections eight to ten yours out is not because that toll bridge business has any 'statistical advantage' (although that might be true as well). It is because the rules of the business game have been so carefully carved in my favour, that anyone who takes the toll bridge operator on will not have a fair fight. In one sentence: "The game is stacked."

SNOOPY

Snoopy
12-12-2007, 09:35 AM
Snoopy, maybe you are getting a bit confused here.



That is very possible 'steve f'



A takeover valuation is VERY different from an Enterprise value.

A takeover valuation incorporates such things as premium for control and the impact of cost savings and synergies etc - all of which are definitely not reflected in the Enterprise value.

Very simply, SURPLUS ASSETS + ENTERPRISE VALUE = DEBT + EQUITY VALUE.

You can calculate the equity value from an Enterprise value and vice versa.


OK so if :

Enterprise value = market capitalisation + interest bearing debt

AND if we assume that all debt in the real world is interest bearing

THEN

Surplus Assets + Market Capitalisation = Equity Value (?)

That doesn't seem right does it? I am struggling a bit to find out what you mean by 'Surplus assets'



In practice you will find the EV/EBIT & EV/EBITDA approach used in assessing value far more often than the P/E approach, for the reasons Stephen outlined.

That is certainly true as far as Sky City is concerned. Every time the share price dipped below $4.50, former CEO Evan Davies came out saying how cheap the company was as a takeover target. The share price went up, the takeover speculation died away, the share price went down then the takeover speculation headline was rolled out again and the whole process restarts.....

Now Evan has gone, the board is continuing on with this same process. SKC must be the most 'valued' company of the last four years. But just because it is valued so often, does that really matter if all of these 'valuations' come to nothing? IMO the typical P/E seems more important, as when the speculation dies down, that determines the price band that the share price will revert to.

SNOOPY

steve fleming
12-12-2007, 02:22 PM
That is very possible 'steve f'



OK so if :

Enterprise value = market capitalisation + interest bearing debt

AND if we assume that all debt in the real world is interest bearing

THEN

Surplus Assets + Market Capitalisation = Equity Value (?)

That doesn't seem right does it? I am struggling a bit to find out what you mean by 'Surplus assets'


SNOOPY

SURPLUS ASSETS = Cash, investments, property etc not integral to the operations of the business

"
OK so if :

Enterprise value = market capitalisation + interest bearing debt"

NO. Thats not correct.

By definition Enterprise Value = market cap + IBD - Surplus assets

Refer to GDM - it has a negative enterprise value due to the value of its suplus assets (investments/cash) exceeeding its market cap.

winner69
15-12-2007, 10:44 AM
That is certainly true as far as Sky City is concerned. Every time the share price dipped below $4.50, former CEO Evan Davies came out saying how cheap the company was as a takeover target. The share price went up, the takeover speculation died away, the share price went down then the takeover speculation headline was rolled out again and the whole process restarts.....

Now Evan has gone, the board is continuing on with this same process. SKC must be the most 'valued' company of the last four years. But just because it is valued so often, does that really matter if all of these 'valuations' come to nothing? IMO the typical P/E seems more important, as when the speculation dies down, that determines the price band that the share price will revert to.

SNOOPY

Interesting you mentioned SKC inn this thread because it does give a good example of comparing different ratios highlighting the impact of debt on those ratios

Could say SKC and Crown are in the same business

Current ratios (historical financials) -

PE .... SKC 24 / Crown 26
EV/EBITDA ..... SKC 11 / Crown 16
EV/EBIT ..... SKC 14 / Crown 20

Big difference between these 2 is that SKC is laden with debt while Crown is debt free (actually has cash on hand)

Whereas the PE ratios are similar (bloody high eh) there is a significant difference in the other 2 ratios

Not making any judgement as to whether either or both are overvalued or undervalued but that EV/EBITDA of 11 that SKC has seems to be one of the stumbling blocks in takeover activity and for SKC I feel that is the meaningful ratio to use

Good thread though

stephen
03-01-2008, 09:17 AM
I mentioned earlier that I was working on a screening tool based on "The Little Book That Beats The Market". To recap, that book recommends a two-stage screen:

Pick companies, say the top 20% of the market, with a high ratio of EBIT to Net Working Capital + PPE. This is meant to be an indicator of how effectively the company generates income from its assets.

Then rank them in descending order of EBIT/EV. This is meant to give a measure of price.

The book suggests building an annual portfolio out of your choice of the results, selling the losers just before tax year end and the winners just after. It also suggests using the tool as a first cut list of candidates for value oriented stock-picking (which is what I intend to do with it).

Here is that ranking as applied to the ASX All Ords. Note that these figures are based on screen-scraping various websites, so there are bound to be anomalies. Perhaps I should do another run that excludes property trusts and investment companies...

code return yield
PMV 108% 80%
AAH 67% 48%
TSO 473% 35%
MOF 351% 24%
MDT 722% 24%
MIG 77% 23%
IOF 509% 22%
PEM 71% 21%
MCW 124% 21%
CPK 457% 19%
SMY 61% 16%
LEP 378% 15%
DRT 496% 15%
CND 63% 15%
IGO 197% 14%
CNP 93% 14%
AIX 367% 13%
MAFCA 98% 13%
AEZ 1508% 13%
TGP 109% 13%
PSA 90% 13%
RAT 375% 13%
MIX 255% 12%
IFM 79% 11%
APZ 138% 11%
IIF 212% 11%
BJT 228% 11%
DVN 62% 11%
MIR 809% 11%
TRG 102% 11%
GOW 66% 10%
MPF 278% 10%
JST 100% 10%
CMW 286% 10%
CWP 189% 10%
RRT 1541% 9%
EZL 95% 9%
DJW 2614% 9%
VGH 67% 9%
CXP 74% 9%
SGN 139% 9%
MGR 64% 8%
ABP 73% 8%
LNN 66% 8%
TPX 63% 8%
AEU 240% 8%
REF 196% 8%
NOD 62% 7%
LLC 70% 7%
AEO 162% 7%
RJT 96% 7%
MND 60% 7%
NCK 66% 7%
MMS 148% 7%
GPT 68% 7%
WHF 140% 7%
CPU 106% 7%
PPT 92% 7%
HHL 110% 7%
ALL 92% 6%
GJT 69% 6%
PFG 243% 6%
PGA 90% 6%
PPC 75% 6%
AUW 131% 6%
PMC 63% 6%
RKN 70% 6%
CAB 69% 5%
SSM 113% 5%
DWS 88% 5%
SKI 566% 5%
WTP 64% 5%
AUI 974% 5%
SHL 4836% 5%
DUI 741% 5%
TGG 107% 5%
AFI 262% 5%
COU 122% 5%
TCQ 74% 5%
VPG 270% 5%
HFA 211% 5%
EQT 82% 4%
CHO 101% 4%
WES 80% 4%
NXS 80% 4%
IPN 84% 4%
MLT 85% 4%
ASX 86% 4%
CHC 168% 4%
COH 115% 4%
SEK 246% 3%
EBB 95% 3%
BVA 122% 3%
IDL 110% 3%
WTF 115% 3%
WOR 71% 3%
NCM 188% 2%
REA 15442% 2%
AAX 59% 1%

Lizard
05-01-2008, 08:34 AM
Nice work Stephen - but going to take a few hours to work through that list - perhaps we should see if we can find 5 volunteers to look at 20 stocks each and come back with comments as to whether the tool seemed helpful in finding good stocks? Or maybe just track progress for a year using the top 20-40 (the most I think any one person is likely to feasibly buy).

OldRider
05-01-2008, 10:21 AM
Stephen:
I am sure your method will find some good investments, as well removing
LPT's, LIC's and similar would make the size much more manageable.

I wrote some years ago about the CGVI filter I use without eliciting much interest, interestingly your list and mine both have a number of the same companies, with roughly the same order. I wonder why WOW did not make your list?

Try a google search on CGVI, there is a lot of information about this filtering formula to be found, including a small web site which has a database covering the entire ASX with fundamental data and calculated values including CVGI. It is useful though only updated erratically.

I have found this filter of great value as an initial filter, and over the years it has winkled out a number of small cap companies that have grown rapidly, or become takeover targets, and has made a considerable return for me.

If you or others are interested, the formula is not complex, I use it in a spreadsheet and would pass it on.

stephen
05-01-2008, 11:25 AM
OldRider, actually I followed your CGVI posts with considerable interest, and I'm not surprised that it yields good results.

My take on CGVI is that you're looking at a price measure in the numerator and a return on assets in the denominator.

All the FA screening tools that are more sophisticated than buying for less than NTA seem to share these elements: how good is the company (return) and how cheaply can we buy it (price).

The reason WOW didn't make the cut is that I arbitrarily restricted the first screening pass to the the top 100 or so on return (defined as EBIT/(NWC + PP&E) ). Even if it did, it's still very expensive. Maybe if I took all the LPTs and LICs out it would make the cut again. I will have a crack later in the weekend.

ratkin
05-01-2008, 11:25 AM
Have made my way down that list as far as ezl They nearly all property or investment trusts.

Only stock of note found so far is ckp which is interesting as we have been discussing that lately on the aussie forum . I hold colorpak , having only recently bought and providing they can keep the work coming in they should be a good investment

stephen
05-01-2008, 05:18 PM
Well, here is that same list with sector information.

Unfortunately, "Real Estate" is rather broad, and so is "Diversified Financials". A more fine-grained culling has to be done by hand - which I may yet do.

return yield
ABP 73% 8% Real Estate
LEP 378% 16% Real Estate
PMV 108% 80% Food & Staples Retailing
AEZ 1508% 13% Real Estate
AAH 67% 47% Pharmaceuticals & Biotechnology
PEM 71% 22% Materials
APZ 138% 11% Real Estate
ASX 86% 4% Diversified Financials
MIG 77% 22% Transportation
AEU 240% 8% Real Estate
AFI 262% 5% Diversified Financials
AUI 974% 5% Diversified Financials
AUW 131% 6% Diversified Financials
BJT 228% 11% Real Estate
CND 63% 15% Commercial Services & Supplies
SMY 61% 15% Materials
IGO 197% 14% Materials
CWP 189% 10% Real Estate
AIX 367% 13% Transportation
CHC 168% 4% Real Estate
CHO 101% 4% Diversified Financials
PSA 90% 12% Energy
IFM 79% 12% Software & Services
COU 122% 5% Diversified Financials
CPK 457% 18% Real Estate
CMW 286% 10% Real Estate
DRT 496% 16% Real Estate
DVN 62% 11% Real Estate
DUI 741% 5% Diversified Financials
DJW 2614% 9% Diversified Financials
EQT 82% 4% Diversified Financials
EZL 95% 9% Diversified Financials
EBB 95% 3% Diversified Financials
GJT 69% 6% Real Estate
VGH 67% 9% Health Care Equipment & Services
GOW 66% 10% Diversified Financials
GPT 68% 7% Real Estate
HFA 211% 5% Diversified Financials
CXP 74% 9% Commercial Services & Supplies
HHL 110% 7% Diversified Financials
JST 63% 9% Retailing
SGN 139% 8% Media
IIF 212% 11% Real Estate
IOF 509% 22% Real Estate
LNN 66% 8% Food Beverage & Tobacco
LLC 70% 8% Real Estate
REF 196% 8% Telecommunication Services
MCW 124% 21% Real Estate
MDT 722% 24% Real Estate
NOD 62% 8% Capital Goods
AEO 162% 7% Media
MOF 351% 25% Real Estate
MND 60% 7% Capital Goods
MLT 85% 4% Diversified Financials
MMS 148% 7% Commercial Services & Supplies
MIR 809% 11% Diversified Financials
MGR 64% 8% Real Estate
MIX 255% 12% Real Estate
NCK 66% 7% Retailing
MPF 278% 10% Real Estate
MAFCA 98% 13% Real Estate
CPU 106% 7% Software & Services
ALL 92% 6% Consumer Services
PGA 90% 6% Media
PPC 75% 6% Real Estate
PPT 92% 7% Diversified Financials
PMC 63% 6% Diversified Financials
SSM 113% 6% Capital Goods
WTP 64% 6% Capital Goods
PFG 243% 6% Diversified Financials
SKI 566% 5% Utilities
RRT 1541% 9% Real Estate
CAB 69% 5% Commercial Services & Supplies
RAT 375% 12% Real Estate
RJT 96% 7% Real Estate
DWS 88% 5% Software & Services
SMX 58% 5% Software & Services
RKN 70% 5% Software & Services
SHL 4836% 5% Health Care Equipment & Services
WES 80% 4% Food & Staples Retailing
IPN 84% 4% Health Care Equipment & Services
NXS 80% 4% Energy
TPX 63% 8% Diversified Financials
TGG 107% 5% Diversified Financials
COH 115% 4% Health Care Equipment & Services
BVA 122% 3% Software & Services
SEK 246% 3% Commercial Services & Supplies
TSO 473% 35% Real Estate
TGP 109% 13% Real Estate
TRG 102% 10% Diversified Financials
TCQ 74% 5% Real Estate
IDL 110% 3% Capital Goods
VPG 270% 5% Real Estate
WTF 115% 3% Retailing
WOR 71% 3% Energy
REA 15442% 2% Media
NCM 188% 2% Materials
WHF 140% 7% Diversified Financials
AAX 59% 1% Capital Goods
PSD 555% -79% Pharmaceuticals & Biotechnology

Lizard
05-01-2008, 06:13 PM
Thanks Stephen... that makes for a much more useful starting point! I don't think the measure would be particularly helpful for resource stocks (I hold IGO and trade SMY though and I quite like PEM...so perhaps it does work for these too. Lol!) or pharma-bio/developing companies (I hold AAH though). However, there are a few interesting ones there - DWS I've picked up on screening before and liked, but never actually bought. Also SGN and CND. Own BJT and CMW of the property trusts, but not sure where they bottom...only beginning to get close to fair value I think. Actually, the more I look, the more I recognise as being ones I've already looked at for various reasons...

OldRider - I follow your posts on CGVI!

Lizard
08-01-2008, 08:23 AM
Re earlier discussions on P/E multiples vs EBIT multiples, I note from some analyst reports that the move towards EBIT comparisons seems to be gathering even more strength from the current uncertainty around debt-rollovers. i.e. analysts are uncertain about timing and magnitude of likely sharp changes to interest costs and are therefore are choosing to take them out of the equation when looking at comparative multiples.

stephen
08-01-2008, 09:45 AM
In the last couple of years I've looked hard at quite a few tech companies. A common factor in ones that have become recently successful is that they pay little or no tax, owing to previous losses. When you start looking at their likely performance once they've used up their tax losses they don't look so good...

Snoopy
05-03-2008, 11:41 AM
Here's a few of my thoughts on valuation:


In current market circumstances where good companies are getting trashed when earnings growth does not fulfill sharemarket expectations, I think it is appropriate to take another look at elements of Liz's valuation list.



Consideration of the balance sheet is essential to any form of valuation - buying "value" alone is likely to direct you into distressed businesses or situations where existing equity is more likely to be diluted. It also misses companies that are positioned to invest in explosive growth.


Buying a share on any one (and only one) indicator is always going to get you into trouble in the end.

If by buying 'value', you mean buying just because a share price is low, or PE is low, I would agree. But I wouldn't agree with 'value' being measured on a one dimensional scale. So I can't agree that 'value' companies are likely to be distressed, or likely to need new equity.

The one exception to this rule is companies that constantly need access to new capital to grow or even retain their current profitability. In that instance, and this includes all finance companies, a falling share price means 'stay away'.

Generally IMO a battered down share price is not a good indicator of a business in long term distress.

Buying 'value' will almost certainly see you miss out on buying companies poised for 'explosive growth' that is true. But value buying also protects the investor from the PE slashing that can halve or more a company's share price when 'explosive growth' is expected but not realised - on no change of *actual* earnings.

Thus I see missing out on buying those 'explosive growth' opportunities to be a good thing.



Valuation should always be forward looking. Seems obvious, but the temptation is to apply formulae which automatically generate a value based on historical data.

Valuation can demonstrate that buying a business with sustainable high levels of earnings growth will mean there is no price too high for a long term holder. This is a valid conclusion - but not always the most profitable thing to do in the short term.


So what you are saying here Liz is that to invest in 'explosive growth' opportunities you have to make up some growth factor (not use a historical projection) and it is very likely that, in so doing, you will convince yourself of the investment case? [since no buy price will be too high if your made up optimistic (why would you invest if you were not an optimist?) projection is right]



Valuation always needs to be considered in the light of market conditions. Profit margins of greater than 20% rarely last. And high returns on assets make a sector attractive for competition.


Just to make things perfectly clear, I believe you are talking about business market conditions not investor market conditions, vis a vis the current state of the sharemarket.

If that is what you mean I agree.

This is why I have balked at increasing my investment in Turner's Auctions over recent months. Not because I didn't believe in the ability of the company to manage its way out of difficulties. It was because I could see the overall second hand vehicle market was experiencing a 'dislocation shock' of a 'once in a decade' magnitude and I wasn't clear how the up until now business model would stand up in those conditions.

As it turned out my fears seem unfounded and I should have piled into the share as it traded under $1- arrrgh! Or perhaps not. At that stage the full year TUA result and business market outlook was not out. So I would have been taking a serious gamble if I had started buying at those sub $1 prices.

As always it is easy to appear clever if you have the benefit of hindsight. Sorting out 'share filters' in advance given you only have historical data to go on is much more difficult!

SNOOPY

Lizard
05-03-2008, 02:18 PM
So I can't agree that 'value' companies are likely to be distressed, or likely to need new equity.

This thread referred to measurement of "value" using P/E and various associated ratios. I would suggest that if I screened the market for stocks and looked for the ones with the lowest P/E, P/S and Pr/NTA ratios (often considered to be measures of value) then I would find the top 10 (i.e. the lowest ratios) was heavily laced with companies that are either about to go broke or to re-finance with heavy dilution. So using these tools to screen stocks tends to get me into trouble unless I take my analysis alot further.

However, maybe in the lows of a bear market, these screening ratios will be more useful than in the picked over bones of an old bull.


Buying 'value' will almost certainly see you miss out on buying companies poised for 'explosive growth' that is true. But value buying also protects the investor from the PE slashing that can halve or more a company's share price when 'explosive growth' is expected but not realised - on no change of *actual* earnings.

And a share that looked to be on a low P/E can easily become a share with a high P/E if my analysis was wrong and the company's earnings decline. ALL shares that disappoint against predictions suffer accordingly, no matter whether they were previously in an uptrend or a downtrend; had a high P/E or a low P/E. If a growth stock turns out to be growing more slowly, then, so long as it continues to grow, it should eventually return my money with interest (assuming a neutral market). If a low/no growth stock turns out to be doing worse than expected, then that probably means that if I hold long enough, I will have nothing left.


So what you are saying here Liz is that to invest in 'explosive growth' opportunities you have to make up some growth factor (not use a historical projection) and it is very likely that, in so doing, you will convince yourself of the investment case?

Not necessarily. I could look at historical return on assets, combine with the balance sheet and payout ratio to determine a sustainable rate of possible growth as my "growth factor". Although this alone might fail me where there are changes in sectoral conditions, or where the business is subject to economies of scale. Or where the business model has changed.

(Whether or not I am easily convinced about the business case will probably depend on my mood, on who is suggesting it to me and on the number of drinks I have had).

Snoopy
06-03-2008, 08:30 PM
This thread referred to measurement of "value" using P/E and various associated ratios. I would suggest that if I screened the market for stocks and looked for the ones with the lowest P/E, P/S and Pr/NTA ratios (often considered to be measures of value) then I would find the top 10 (i.e. the lowest ratios) was heavily laced with companies that are either about to go broke or to re-finance with heavy dilution. So using these tools to screen stocks tends to get me into trouble unless I take my analysis a lot further.

However, maybe in the lows of a bear market, these screening ratios will be more useful than in the picked over bones of an old bull.


I agree that Low P/E *could* mean a company is about to go broke or refinance with heavy dilution. However, there are other financial statistics you can check that will save you choosing a company with such a potential fate. I think to discard low P/E companies, because low PE 'might be bad' is wrong.

Here is a comprehensive reference on buying low P/E companies.

http://www.ftpress.com/articles/article.aspx?p=170894&seqNum=3

From that particular page I reference, I quote the salient paragraphs:

----------

Low PE Stocks versus the Rest of the Market

Studies that have looked at the relationship between PE ratios and excess returns have consistently found that stocks with low PE ratios earn significantly higher returns than stocks with high PE ratios over long time horizons. Since some of the research is more than two decades old and the results vary widely depending upon the sampling period, it might be best to review the raw data and look at the longest period for which data is available.

Begin by looking at the annual returns that would have been earned by U.S. stocks categorized into ten classes according to PE ratios from 1952 to 2001. The stocks were categorized by PE ratios at the start of each year, and the total return, inclusive of dividends and price appreciation, was computed for each of the ten portfolios over the year.

On average, the stocks in the lowest PE ratio classes earned almost twice the returns of the stocks in the highest PE ratio classes. To examine how sensitive these conclusions were to how the portfolios were constructed, you can look at two constructs. In the first, equally weighted portfolios were created, and an equal amount of money was put into each firm in each portfolio. In the second, more was invested in the firms with higher market value and less in the smaller firms to create value-weighted portfolios. The results were slightly more favorable with the equally weighted portfolio, with the lowest PE ratio stocks earning an average annual return of 24.11% and the highest PE ratio stocks earning 13.03%. With the value-weighted portfolios, the corresponding numbers were 20.85% and 11%, respectively. In both cases, though, low PE stocks clearly outperformed high PE stocks as investments.

To examine whether there are differences in subperiods, let's look at the annual returns from 1952 to 1971, 1972 to 1990, and 1991 to 2001 for stocks in each PE ratio portfolio. Again, the portfolios were created on the basis of PE ratios at the beginning of each year, and returns were measured over the course of the year.

Firms in the lowest PE ratio class earned 10% more each year than the stocks in the high PE class between 1952 and 1971, about 9% more each year between 1971 and 1990, and about 12% more each year between 1991 and 2001. In other words, there is no visible decline in the returns earned by low PE stocks in recent years.

Thus, the evidence is overwhelming that low PE stocks earn higher returns than high PE stocks over long periods. Those studies that adjust for differences in risk across stocks confirm that low PE stocks continue to earn higher returns after adjusting for risk. Since the portfolios examined in the last section were constructed only with stocks listed in the United States, it is also worth noting that the excess returns earned by low PE ratio stocks also show up in other international markets.

--------

End quote




And a share that looked to be on a low P/E can easily become a share with a high P/E if my analysis was wrong and the company's earnings decline. ALL shares that disappoint against predictions suffer accordingly, no matter whether they were previously in an uptrend or a downtrend; had a high P/E or a low P/E.


Yes except that a stock with a low P/E has probably *already* disappointed the market. So there is less chance of a low P/E stock not meeting favourable market expectations. With a low PE stock, I am thinking of TUA as a recent particular example in my portfolio, they recently declared a net profit from continuing operations down some 25%. Following that declaration the share price promptly *gained* 25%, simply because although the result was bad, it wasn't as bad as people thought.

If you start on the bottom rung of the ladder, you often don't have as far to fall.



If a growth stock turns out to be growing more slowly, then, so long as it continues to grow, it should eventually return my money with interest (assuming a neutral market). If a low/no growth stock turns out to be doing worse than expected, then that probably means that if I hold long enough, I will have nothing left.


Most 'bad businesses' are cyclical. It is quite rare that a well capitalised business that is nevertheless operating in a difficult environment goes down.

I do tend to invest in low(er) PE shares myself. As an exercise I have done a bit of analysis on Scott Technology which I had thought of as a 'relatively low PE' share. However on going over my data I have found my idea was quite wrong. The PE, as at September 30th leading up to the annual result, has varied enormously from a low of 11.2 to a high of 200!

I therefore have the basis of a small study. I have only nine years of data points - not enough to claim any result really means anything. But I think you will find the results interesting nonetheless.

I have calculated the return on a year on year basis going forwards (capital gain and dividends) and got a percentage return. I have then compared the return with the market PE prevailing just before the year studied. The results are as follows:



Prevailing PE Ratio Total Annual Return

11.2 +31.5%
12.2 -48.5%
13.0 +30.6%
14.8 +53.6%
15.2 +7.6%
22.7 -24.0%
40.3 +71.7%
195 -20.6%
200 -2.5%


This is not an absolutely clear cut picture. The very best result occurred when the PE ratio was 40.3 (high) and the worst result occurred when the PE was 12.2 (quite low). The overall picture, though, paints with the opposite brush. On 80% of occasions a low PE is the portent to a good investment result while a high PE is a strong indicator of doing badly. That does not contradict the premise that 'most of the time' - if you screen out the companies in trouble (an important qualifier) - a low PE investment will outperform a high PE investment.

SNOOPY

Lizard
16-11-2008, 12:23 PM
I was looking back at this thread this morning and decided to go to more than a bit of trouble to try and see what would have worked as a selection tool back in December 2007...

So I've taken historical ASX data from Dec 2007 and put it alongside current and deleted any that don't match (which means anything that has substantially changed it's name, gone broke or been taken over). Then I ran a straight price comparison and deleted any obvious recapitalisations. Data is not going to be perfect, but should be enough to be interesting.

Anyway, some first off results....
Of 1822 shares that survived the data matching, there was an average loss in the 11 months of 53.6% (excl divs)..... considerably worse than the index move.

Only 75 shares or 4.1% had recorded an increase in share price. I called these the "gainers". Below is a table showing the difference in averages for a variety of parameters between the "gainers" and the "market"...

http://www.sharetrader.co.nz/picture.php?albumid=2&pictureid=68

Perhaps surprisingly, the most significant difference between the gainers and the market averages is in P/E - with the average much higher for the gainers at the beginning of the measured period! ROE was much lower, as was yield. Pr/NTA was slightly better, but not considerably and has ended the year higher, while the ROE for the gainers is now consistent with the market.

The most notable point from this is that the market cap has gone up for "gainers", while P/E has fallen. The change in both these numbers can be used to calculate that the average change in earnings for the gainers was an increase of 104%! Earnings for the market as a whole must have fallen by an average of 6.4%.

I may try later to do some more manipulation of the data and see what other interesting facts fall out... (e.g. one noticeable feature in preparing the data is that the most comings and goings occurred in companies with names starting with "green"! :p)

(Note that the source data excludes extreme results from the calculation of averages, so the full data set may not have been included in any given average).

Lizard
16-11-2008, 02:58 PM
Okay, just ran the comparison for Stephen's list from his Dec/Jan screening of the market based on "the Little Book that beats the Market"...

.... and, it didn't beat the market. (Though I doubt the results would pass a significance test given the wide Std Deviations. Distributions should be skewed anyway, given there is a downside limit of 100%)

Market average return = -53.6%
The LBtBtM = -61.8%

Lizard
16-11-2008, 06:25 PM
It's interesting to look at Median results rather than averages...

Whereas the average loss for market was 53.6%, the median loss was actually 61.2%

More interesting - the median market cap for the ASX turns out to be radically different from the mean at a mere $34m, while the group of "gainers" were even more biased towards minnows, at a median market cap of just $16m.

Snoopy
17-11-2008, 10:53 AM
I've taken historical ASX data from Dec 2007 and put it alongside current and deleted any that don't match (which means anything that has substantially changed it's name, gone broke or been taken over). Then I ran a straight price comparison and deleted any obvious recapitalisations. Data is not going to be perfect, but should be enough to be interesting.

Perhaps surprisingly, the most significant difference between the gainers and the market averages is in P/E - with the average much higher for the gainers at the beginning of the measured period! ...


Lizard, can you explain why your P/E statistics for December 2007 are so high? I would describe the December 2007 whole of market P/E of 30.2 as high (perhaps not surprising at the end of a bull market run), but the 'gainers' historic December 2007 P/E of over 50 is extraordinary. Is it possible that because the gainers sample was so small that you have identified some kind of statistical aberration? Just who were these gainers and can you identify any underlying theme that is driving this very high -in absolute terms- P/E result?

Also, how did you calculations deal with P/E ratios for those companies that reported negative earnings?



...ROE was much lower, as was yield.


That ties in with other research results which shows the best overall outperformance statistic is to look for companies with valuable underlying assets in relation to sharemarket price, regardless of P/E.



Pr/NTA was slightly better, but not considerably and has ended the year higher,


Interesting is the decline in market capitalisation for 'the market' of 40% in parallel with the decline in 'price to net asset value' of 44% (seems logical, assets are not worth what the market once thought they were and so the market price declines in tandem)...

...seen in comparison with the *increase* in market capitalisation for 'the gainers' of 35%, compared to a decline in 'price to net asset value' of 31% for 'the gainers'. Why is the market taking such an optimistic view of 'the gainers' (boosting market capitalisation) yet the market price payable for those gainers underlying net asset values appears to have shrunk? Am I reading your chart correctly Lizard?



while the ROE for the gainers is now consistent with the market.


Brought about by new accounting rules requiring assets values to be marked to a market valuation based on the return those assets give?



The most notable point from this is that the market cap has gone up for "gainers", while P/E has fallen.....


The gainers P/E has fallen from around '50' Lizard, which as I said before was an extraordinarily high absolute figure. Surely you could only expect the P/E to fall from those levels?



The change in both these numbers (P/E and Market Cap) can be used to calculate that the average change in earnings for the gainers was an increase of 104%! Earnings for the market as a whole must have fallen by an average of 6.4%.


You have recorded the market prices precisely but what about the Earnings? Is it possible that because your comparison covers only 11 months that some of those reported earnings have not been updated year on year?

SNOOPY

Lizard
17-11-2008, 02:47 PM
Snoopy, as you can probably imagine, it is a pretty rough exercise and dependent on the accuracy of the database source.

The averages for P/E exclude negative data. Therefore, a few very high multiples in the "gainers" have skewed the data - the median turns out to be a P/E of 16 at start for both "market" and "gainers".

Looking over the data, it looks like the gainers include a few large caps with small gains (e.g. CSL), some takeover targets (ORG, RPM, SHG) with a larger proportion of minnows - perhaps businesses emerging from the "embryonic" stage such as QML and ACG or resource minnows who struck it lucky (MAK?).

The Pr/NTA data is absent in the database for many very small companies or where negative and therefore cannot be included. The anomaly in the data for "gainers" seems to come from data for some of these companies being added to the database as their market cap increased. So unfortunately, perhaps not too meaningful!

I have since tried analysing results for different groups of stocks based on starting parameters (e.g. P/E<10) and not alot stands out - they are all pretty grim and fairly similar averages of 50-60% fall! Larger stocks seemed to have generally fallen less.

Not alot of lessons for what to hold through a bear market - except "don't".

Snoopy
18-11-2008, 09:17 AM
Snoopy, as you can probably imagine, it is a pretty rough exercise and dependent on the accuracy of the database source.

The averages for P/E exclude negative data. Therefore, a few very high multiples in the "gainers" have skewed the data - the median turns out to be a P/E of 16 at start for both "market" and "gainers".

Looking over the data, it looks like the gainers include a few large caps with small gains (e.g. CSL), some takeover targets (ORG, RPM, SHG) with a larger proportion of minnows - perhaps businesses emerging from the "embryonic" stage such as QML and ACG or resource minnows who struck it lucky (MAK?).


OK, so it looks like your first finding Lizard:

"The most significant difference between the gainers and the market averages is in P/E - with the average much higher for the gainers at the beginning of the measured period!"

is not so significant if you change from the 'arithmetic average' to the 'median average'.

I guess that was always on the cards with a small sample that can be easily skewed by one or two pieces of outlier data.



Snoopy wrote:

"Why is the market taking such an optimistic view of 'the gainers' (boosting market capitalisation) yet the market price payable for those gainers underlying net asset values appears to have shrunk?"

The anomaly in the data for "gainers" seems to come from data for some of these companies being added to the database as their market cap increased. So unfortunately, perhaps not too meaningful!


Perhaps to balance out this 'new company' data anomoly, you could remove the December 2007 market capitalisation of those 'old' companies that went bust over the year?



I have since tried analysing results for different groups of stocks based on starting parameters (e.g. P/E<10) and not alot stands out - they are all pretty grim and fairly similar averages of 50-60% fall! Larger stocks seemed to have generally fallen less.

Not a lot of lessons for what to hold through a bear market - except "don't".


I think it is more a matter of selecting stocks by just one simple statistic (P/E ratio) not being a credible investment strategy, no matter how good that statistic appears to be on its own. By all means use P/E, but use other statistics in tandem.

In a 'financial crisis', I would expect those companies that do 'well' (in relative terms) to have quite a high P/E ratio. Why? Because companies that have their earnings valued highly by the market are valued highly because of the robustness of their underlying earnings streams in *all* market conditions.

SNOOPY

Snoopy
22-11-2008, 09:01 AM
"In a 'financial crisis', I would expect those companies that do 'well' (in relative terms) to have quite a high P/E ratio. Why? Because companies that have their earnings valued highly by the market are valued highly because of the robustness of their underlying earnings streams in *all* market conditions."

Well Snoopy, Id love for you to find one of these stocks?

Who has a high PE in this market that has maintained a high PE because of robust underlying earnings

underlying earnings are so unpredicable now, I beg to disagree

to have both now is nearly impossible?? no


Out of my own portfolio I will pick three shares with

"a high PE in this market that has maintained a high PE because of robust underlying earnings"

for you Underdog.

1/ Lyttelton Port of Christchurch: PE of 22.8 before yesterday's bid, PE now is 26.6
2/ Contact Energy: PE of 15.9, even after yesterday's share price plunge. It was over 17 with the share price over $7.
3/ Lion Nathan: PE of 17.8 for FY2007. Haven't recalculated for this year yet. But earnings are up modestly 5%? while the share price has fallen by about 5%. That leaves the PE at around 16 which is being depressed by the LNN's hostile bid for Coca Cola Amatil which is on the table.

None of these companies is forecasting an earnings decrease. LNN is quite the opposite, predicting a noticable step up in earnings for FY2009.

SNOOPY

discl: hold LPC, CEN, LNN

OldRider
02-10-2009, 07:49 PM
Google "Z score", to find a formula for checking a companies health.

I have a disproportionate investment in Qmastor for the size of the company,
Z score for QML is 10.71 which leaves me happy with the investment.

Lizard
16-05-2011, 09:42 PM
Came across Piotroski the other day and thought he might belong on this thread as another possible fundamental stock-picking method. Suspect the theory works best during a market beat-up though, as imagine the stocks get hard to find when the market is going okay.

Basic theory is to select from stocks with a low Price/NAV (lowest 20%) and then screen them for 9 success factors:
positive ROA,
positive Op Cashflow/Assets, annual increase in ROA, Op Cashflow > Net Profit (before abnormals), decreasing "leverage" long-term debt/assets, increasing current ratio (current assets/current liabilities), no new equity issued in past year, increasing annual % gross margin, increasing asset turnover (sales/assets).

The paper discussing the test of this theory is found here (http://www.chicagobooth.edu/faculty/selectedpapers/sp84.pdf).

According to Forbes (http://www.forbes.com/2009/02/23/piotroski-investors-strategy-personal-finance_piotroski.html), it seemed the theory worked pretty well in 2008. Not particularly surprising - Pr/NTA based selection usually works best in a market rout. The screens would definitely help - and makes me wonder if just using the screens and ignoring the Pr/NTA might be more successful in other years.

Unfortunately, it's all very well having a nice screen tool like this, but having the database that will allow it to be used is probably not realistic. And, if doing the calcs manually, then might as well be working to look for stocks that seem likely to pass those screens on the next result, rather than on the historical one.

OldRider
17-05-2011, 07:03 AM
It would look to me after a quick read, a fairly reliable set of criteria for sorting out growth companies.
I use a scan which is simpler, though similar in that the result is strengthened by a high return on assets.
Its advantage is its simplicity as the data required can be got without much difficulty.

The results need to be sifted because there is always a predominance of IT and similar companies, which
have as much potential to go broke as they do to grow, however
over the years it has produced for me a number of gems, Oamps, Data #3 and Worley come to mind.

Interestingly, when I ran the project a month or two ago, on combined ASX and NZX data, not a single
NZX company made the list for further study. Over the years I have mentioned the formula I use without
attracting much interest, perhaps for new posters you could google CGVI if interested, the idea is not new, it had
its origin with Buffet and Munger many year ago.

The system though has little if any use for short term traders but for longer term investors I think it has it merits.

BIRMANBOY
26-05-2011, 01:47 PM
Hi lizard, I was nodding off by page 3!! I suppose everyone is constantly looking for the perfect investment strategy and it seems that a fair proportion of traders have gone into the mode of "the more complicated the system the more probable the chance of beating the averages". What happened to the "buy low sell high" system. Surely this has the perfect formula...buy when a share is in a trough (not in a death spiral) and sell when it reaches a point of resistance. The great thing is you dont need any formulas just the historical charts to provide you with the necessary data. Too simple??? I dont know. What do the readers think?
Came across Piotroski the other day and thought he might belong on this thread as another possible fundamental stock-picking method. Suspect the theory works best during a market beat-up though, as imagine the stocks get hard to find when the market is going okay.


Basic theory is to select from stocks with a low Price/NAV (lowest 20%) and then screen them for 9 success factors:

positive ROA,
positive Op Cashflow/Assets,
annual increase in ROA,
Op Cashflow > Net Profit (before abnormals),
decreasing "leverage" long-term debt/assets,
increasing current ratio (current assets/current liabilities),
no new equity issued in past year,
increasing annual % gross margin,
increasing asset turnover (sales/assets).

The paper discussing the test of this theory is found here (http://www.chicagobooth.edu/faculty/selectedpapers/sp84.pdf).

According to Forbes (http://www.forbes.com/2009/02/23/piotroski-investors-strategy-personal-finance_piotroski.html), it seemed the theory worked pretty well in 2008. Not particularly surprising - Pr/NTA based selection usually works best in a market rout. The screens would definitely help - and makes me wonder if just using the screens and ignoring the Pr/NTA might be more successful in other years.

Unfortunately, it's all very well having a nice screen tool like this, but having the database that will allow it to be used is probably not realistic. And, if doing the calcs manually, then might as well be working to look for stocks that seem likely to pass those screens on the next result, rather than on the historical one.

JemT
26-05-2011, 08:17 PM
Simple, at least to start with, is always the best way of doing this sort of thing. I am only just getting into company valuations (that is studying them, sadly I am not sure I can find a job actually doing them), so the only advice I can give at this stage is to start out simple then refine your techniques by adding layers. Make sure you always take a step back and look at your results from a common sense point of view. One of the worst valuations I have seen involved some guys doing a highly technical analysis, involving about 8 years' of past data, which came out with a valuation that could not be corroborated with the company itself.

Regarding specific ratios, from what I have learned:

Price/Sales can be useful in identifying overvalued companies (P/S > 2-3), but it falls down due to the fact that it does notreally take into account the operations of the company. Some companies might be overly indebted which means a large interest expense taking a chunk out of their bottom line, likewise some might have managers pissing away cash on various things, or large capital maintence requirements.

P/E is so popular that it has been suggested that (some) companies are (may be) valued on this basis. However you need to be careful in the areas of leverage, nonsensical profit figures (i.e. the companies who took a big deferred tax hit in 2010, or who have restructuring charges), and high growth expectations (internet companies/companies going into China etc).

EV/EBITDA, if you can get reliable comparative multiples then this is a good measure to use. Just remember you must always subtract debt, add surplus assets, and subtract minority interests to get the equity figure. It would be a big mistake if you forgot to subtract debt and perceived the company to be undervalued.

Price/Free Cash flow has issues around the consistent calculation of freee cash flow. There are so many ways to do this, so to get a good comparative figure you might need to compute the comparable companies' FCF figures yourself.

The best ratio often depends on the nature of the company. A cash flow based ratio is more suitable to a company that generates a lot of cash flow (Skycity, Vector, etc). An earnings growth based ratio will be better suited to a company with reasonable growth prospects.

This is just how I see things after about 10 weeks' of studying this area. The advice on here is fantastic because it is all so practical and based on real experience; textbooks only get you so far, and I am quite convinced that my university lecture does not actually know the first thing about buying/selling shares.

buns
27-05-2011, 08:38 AM
I’m an Multiples (some could say lazy) guy

I will use the EBITDA Multiple if I don’t understand their capex very well, know they don’t spend much on it, or simply have no chance of finding the investment and maintenance CAPEX side of it. Because like the PE ratio ignores the balance sheet, I think the EBITDA multiple ignores a lot of the cash flows.

An EBIT/EV multiple reigns supreme, as this takes into account depreciation which is a result of your stay in businesses (maintenance I call them) assets, hence any increase and decrease in those should align to the same trend in CAPEX spend.

The downfall with this is that depreciation relates to prior periods, and current capex spend won’t be reflected. So if the business has embarked on any kind of growth or a major change in its asset base you would think the current deprecation numbers might not reflect the future ones from your current capex spend.

Taking this into account, one of my new favourites is the FCF/EV ratio – essentially it gives a time value, or pay back on your investment. For FCF I just use operational cash flow which is EBITDA less maintenance capex.

As a whole, using these is definitely an art. Depending on a companies size/maturity, or stage in its lifecycle the combinations of comparatives you use should be very different. I meantioned it on the RYM thread, that all of my comparables (valuation skill set) didn’t help to much for a company like that which demanded a higher valuation because of other things.

You need to be carefull.. Telecom for the last 5/6 years has had an EV/EBITDA around 5 or 6 and a PE below 10… Where would that have got you

The Devil is in the detail.

Lizard
28-05-2011, 08:09 AM
In my view, ratios are just a screening tool and only as useful as the database you can access to find them. If there isn't a site that gives the ratio for all stocks on the ASX so that you can sort out the best ones to hunt through, then there isn't much point. Might as well start at the "A's"

Value measurement does not tend to indicate the direction of a share price, only the speed with which it can rise or fall. Which is where value parameters can put the octane in a portfolio.

However, once eyeballing a stock then it is the direction of profits and the speed of change in the future that is the focus, since that is the key element of a rising share price. Ratio's may provide a few clues as to what is possible, but it is more subjective guesses and assumptions that will be essential. (At least having made these guesses, each result or forecast can be rapidly scanned to see if things are on track.)

Finding companies that have transparency and consistency in their approach will generally reduce the range of likely outcomes. Lower risk is usually a positive, particularly for slow-moving types who are looking for the mid-long term trades.

Te Whetu
28-05-2011, 08:51 AM
Might as well start at the "A's"

Problem with the "A's" is that's where everyone starts...

It's like buying a lotto ticket when there is a massive jackpot (i.e. + EV) and getting the numbers 1, 2, 3, 4, 5, 6 ... there are generally more than 10 other people who have the exact same numbers. Unless you think you're going to get through all the stocks in the index you should possibly start with a news paper and base your first selection criteria on PE multiples, it's all about maximising outcomes for a given amount of time input. This only works if you know you don't want to invest in a certain range of PE multiples (given other things are also true of course).

As for a data source, I use sites like yahoo finance + an excel macro for to scan stocks. It requires a good understanding of excel, but it's free. Otherwise there are plenty of paid tools out there.

Snoopy
16-10-2020, 12:47 PM
The ten year Govt stock risk free rate was 0.55% the other day when I looked.
Ben Graham's well known PE for a no growth company was 8.5 for a 10 year risk free rate of 4%. 1 / 8.5 = earnings yield of 11.76% WHICH
is a 7.76% premium over the risk free rate.

Using that same premium over the risk free rate now gives 7.76% + 0.55% = required earnings yield of 8.31% = PE of 12.
With interest rates where they are and looking to stay at historical lows for the foreseeable future I see the right PE for a no growth company as 12.


This post doesn't really follow from the other posts in this thread from umpteen years ago. But I think it should go here nevertheless.

I pulled the above quote from the Oceania thread, Beagle post 6891.

Beagle has used an 'fixed premium' of 7.76%. I think it is interesting to consider to use of a multiplicative premium calculated as follows: 11.76%/ 4% = 2.94

No risk rate = 0.55%

Required earnings rate = 0.55% x 2.94 = 1.62%, which implies a PE of 100/1.62 = 62

So by this logic it makes sense to buy just about whatever you like because interest rates are so low ;-P

SNOOPY

Beagle
24-10-2020, 08:56 AM
Bad dog. Stick to the fundamental's. PE of 12 is correct for a no growth company.
Ben Graham's theory was no growth PE + 2g x last years eps. (Where g is the anticipated average growth rate for the next 7-10 years).
Of course it goes without saying the trick here is just the "small" matter of trying to estimate what g is for any given company.

My own theory of trying to find growth at a reasonable price (GARP) stocks is to use this formula.
No growth PE plus 1g x next years estimated eps.
A worked example is probably a good idea which will give an illustration of why OCA is my biggest position on the NZX.
I have estimated next year annualized eps at 12 cps, (FY21 includes a change of balance date so will be 10 months and I think will be 10 cps).
SUM and RYM have proven its possible to grow at an average annual growth rate of approx 15% and I think this is a reasonable guess for g.

So value to me for OCA is a PE of 12 for no growth plus 1g = 15 = 27 times next year's earnings of 12 cps = $3.24.

This represents my belief of the intrinsic value of the company today but of course the market does not recognise that as a relative newcomer to the NZX OCA can grow as fast as SUM and RYM have so it will have a considerably lower PE until it can prove that growth rate is sustainable over a number of years.

What does this all mean to this dog ?
I expect over the years ahead that OCA's share price will grow strongly from its increasing eps.
I also expect the market to start to appreciate the merits of OCA's business model which could lead to not only strong growth from eps increasing but also from an expanding PE multiple.

I think its quite plausible that this could lead to very strong market outperformance in the years ahead.

percy
26-10-2020, 04:32 PM
Below are some figures from an Aussie company I have shares in.
Three questions.
1]What would you guess their 2021 eps will be.?
2]What should their current PE be ?[note I think 13.48 is way off.]
3] What forward PE ratio do you think this company warrants.?

......2017...........2018.........2019.........202 0.
eps......06.............08...........1.6.......... 2.3
eps growth.....33%.........100%........43%
Current PE ratio 13.48.....and compare that with growth rate..
Yield 4.52%
1st quarter PBT up 19%
Debt now 0.9mil [30th June 2020] down from $2.3mil[30th June 2019]

Snow Leopard
26-10-2020, 07:44 PM
Below are some figures from an Aussie company I have shares in.
Three questions.
1]What would you guess their 2021 eps will be.?
2]What should their current PE be ?[note I think 13.48 is way off.]
3] What forward PE ratio do you think this company warrants.?

......2017...........2018.........2019.........202 0.
eps......06.............08...........1.6.......... 2.3
eps growth.....33%.........100%........43%
Current PE ratio 13.48.....and compare that with growth rate..
Yield 4.52%
1st quarter PBT up 19%
Debt now 0.9mil [30th June 2020] down from $2.3mil[30th June 2019]

The answer to all three of those questions is impossible to answer if you do not know what the future expectations of the company are.
Whilst the past performance of the company is useful, it is only so in context.


So, you analyse the company and it's market you make your educated guesses on future turnover, profit/loss, dividend, possible new share issues for a number of years ahead.

You weight/discount said numbers according to your appropriate model & the probability that your crystal ball is correctly seeing the future and out comes a value curve: being the calculated market value per share of this stock at intervals over the next year or two.

Your panther instincts tells you the result is way out and you make up some dubious fudge factor to fiddle the numbers.

Then if the current value is less than the current market price you don't buy it and if the current market price is less than the current value then you consider whether the discount makes it worth buying.

The P/E ratio does not actually come into it at all.


https://wwf.ca/wp-content/uploads/2018/09/Small_WW139359-392x600.jpg
7 fascinating facts about snow leopards (https://wwf.ca/2018/09/24/7-fascinating-facts-snow-leopards/)

couta1
26-10-2020, 08:19 PM
The answer to all three of those questions is impossible to answer if you do not know what the future expectations of the company are.
Whilst the past performance of the company is useful, it is only so in context.


So, you analyse the company and it's market you make your educated guesses on future turnover, profit/loss, dividend, possible new share issues for a number of years ahead.

You weight/discount said numbers according to your appropriate model & the probability that your crystal ball is correctly seeing the future and out comes a value curve: being the calculated market value per share of this stock at intervals over the next year or two.

Your panther instincts tells you the result is way out and you make up some dubious fudge factor to fiddle the numbers.

Then if the current value is less than the current market price you don't buy it and if the current market price is less than the current value then you consider whether the discount makes it worth buying.

The P/E ratio does not actually come into it at all.


https://wwf.ca/wp-content/uploads/2018/09/Small_WW139359-392x600.jpg
7 fascinating facts about snow leopards (https://wwf.ca/2018/09/24/7-fascinating-facts-snow-leopards/) Yep PE ratios are a very inconsistent way to value an investment or whether you should buy a given stock or not eg CNU on a PE of 70ish take a look at the sp rise over the last few yrs and the charts, seems completely nuts to me but people keep buying and the price keeps rising, divvy yield is also average, its basically a no growth company on over twice the PE of A2.