**The Nuts and Bolts of this Valuation Method**

Let's break this down into small steps and use an example as we go along. We'll use our trusty Smart Widgets Inc. example here, too.

**Current EPS:**

First, we need the EPS from the latest Income Statement for Smart Widgets Inc.

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We're interested in the "Diluted Normalized EPS". $2.8 is the EPS for the latest financial year.

**Growth Rate:**

How much do we anticipate the company's EPS to grow per year? Let's look at Smart Widgets' EPS growth for the last 5 years.

From 2007 to 2008, EPS grew from 2.26 to 2.8 — about 23% growth. What about from 2006 to 2008? 1.97 to 3.35 — 36% average growth per year compounded. Similarly, considering 2005 and 2004 EPS, we compute an annual compounded growth of 23% and 34% respectively.

Wondering how we did this calculation? It's the compound interest formula:

A = P(1+R) ^N, where

A = Current EPS (Amount)

N = Number of years

P = EPS N yrs. prior (Principal)

R = Annual Growth Rate (Interest rate)

R is the unknown ... so we solve for R. So, for example, four years ago the EPS was 0.87 .... P in our equation. Plugging in the values:

2.8 = 0.87*(1+R)4

Solving for R, we get 0.34 or 34%.

We have quite a range for annual growth ... 23 to 34%. We could take the average of these two extremes or we could just take the minimum .... your call. Let's say you're in a conservative frame of mind. We'll go with 23% as our historical EPS growth rate.

**Future EPS:**

How much would our current EPS be 10 years from now? We'll use our conservative historical growth rate of 23% as an estimate. We're going to use the compound interest formula here again. Start with our current EPS of 2.8 (Principal) and grow it at 23% every year for 10 yrs —

A = P(1+R) ^N, where

A = EPS 10 yrs. from now (Amount)

P = Current EPS (Principal)

R = Interest rate

N = Number of years

Plugging in the numbers,

A = 2.8*(1+0.23)10

A = $22.19 ..... our projected EPS 10 yrs. from now.

**Future Value per share:**

How much would a share of Smart Widgets Inc. cost 10 yrs. from now? We projected an EPS value. Now we need an estimated PE ratio to get this number. Let's see what the PE ratio looked like the last 10 yrs.

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We can see a range from 7.3 to 17.5. If we average these two extremes, we get 12.4 The average of the 10 numbers is 11.7. Let's go with a conservative estimate of 10 for the PE ratio.

Projected Share value (or stock price) in 10 yrs. = EPS * PE

= $22.19 * 10 = $221.90

**Current Valuation or "Intrinsic Value"**

So if the stock price of Smart Widgets Inc. is estimated to hit $159.50 ten years from now, how much should we pay for it today? That depends on how much you intend to grow your investment every year. Let's say you're looking for a growth of 15%. To calculate our current stock price assuming a 15% growth each year, we use ..... you guessed it... our favorite compound interest formula again.

A = P(1+R)N, where

A = Stock Price 10 yrs. from now (Amount)

P = Current Stock Price (Principal)

R = Desired Growth rate

N = Number of years

$221.9 = P*(1+0.15)10

**Bottom Line?**

Calculating for P, we get a current stock price of $54.86. This is also called the "intrinsic value" of the stock.

**How Good is this Stock Price Estimate?**

How accurate is this number? It's really an estimate based on our projection of how the EPS is going to grow and our assumption of the PE ratio. That is why we use this number only as a ballpark. We use an important tool called margin of safety to protect us against assumptions we've made that might turn out to be wrong.

**In summary,**here are all the numbers we used for our calculation. This is an important stock valuation method that uses EPS projected growth and the historical PE ratio to calculate the "intrinsic value" of a stock.

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Source:http://www.independent-stock-investing.com

Last edited by sriranga on Sat Feb 11, 2012 8:00 am; edited 2 times in total