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Thread: PE ratio

  1. #1
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    Lightbulb PE ratio

    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.

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    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.

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    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&#37 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...

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    Zyreon,

    Here's a few of my thoughts on valuation:

    1. 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.
    2. 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.
    3. Valuation should always be forward looking. Seems obvious, but the temptation is to apply formulae which automatically generate a value based on historical data.
    4. 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.
    5. 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.
    6. 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.

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    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

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    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...

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    "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.

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    Quote Originally Posted by zyreon View Post

    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!

    Quote Originally Posted by zyreon View Post
    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.
    Share prices follow earnings....buy EPS growth!!



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    Quote Originally Posted by Lizard View Post
    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!
    Share prices follow earnings....buy EPS growth!!



  10. #10
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    Quote Originally Posted by zyreon View Post
    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
    Watch out for the most persistent and dangerous version of Covid-19: B.S.24/7

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