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Thread: PE ratio

  1. #11
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    Quote Originally Posted by steve fleming View Post
    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

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    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.

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    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.

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    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?

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    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.
    Share prices follow earnings....buy EPS growth!!



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    Quote Originally Posted by steve fleming View Post
    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.

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    Quote Originally Posted by SectorSurfa View Post
    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
    Last edited by Snoopy; 08-12-2007 at 07:09 PM.
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    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.

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    Quote Originally Posted by SectorSurfa View Post
    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
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    Quote Originally Posted by stephen View Post
    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
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