Computation of “Justifiable Price Earnings Ratio”

lion wrote:Hi friends, I am visiting this forum after a long gap, as many are sharing there views on individul stocks I would like to share the theory on justifiable PE. There is a wrong consensus among many local investors that the any stock of PE below 10 is undervalued, above 15 is overvalued, and anything in-between 10 -15 is fairly valued.

According to financial theory, the PE which is unique to individual stocks, justified by its earnings, dividend payout, growth in earnings and the required rate of return of investor is known as the Justifiable PE Ratio. The formula is derived from the Gorden Growth Model formula. Using this formula we can estimate the justifiable PE of a stock.

Based on forward earnings, the formula is simply (payout ratio)/(r-g), where r is the required rate and g is expected growth rate.
Example,
CFIN.
Average dividend payout is 11%, thus retention ratio is 89%
r- required rate, assuming 15% ( which can be computed using further financial techniques such as CAPM)
Growth rate-10% (the GDP growth rate is at 8% and assuming the company would be able beat the GDP growth rate)
Justifiable PE=0.89/(0.15-0.1)-17.8 x
Based on theoretical computation CFIN should be trading at a leading PE of 17.8x.
CFIN projected minimum EPS 2011/2012= 25.x4=100
Justifiable PE =100*17.8=1,780.00

CFIN is just an example I was working on, and is not intended to promote the stock.

Its high time the Sri Lankan investors to learn the theories of capital markets if they are to survive and beat the market in the long run. For more information please Google “Justifiable Price Earnings Ratio” you will find enough articles on this.

Please share your thoughts and comments .

Hope article was helpful.

Have a good week ahead guys.

lion wrote:Hi Slstock,

Thank you for your valuable feedback, I really appreciate it. I will try my best to answer your questions.
Before doing that I want to stress that this is not to for promoting a stock (manipulating) rather I want educate the investors that there are technical methods used to compute the theoretical PE of a stock.

a) not every investor will be willing to follow and agree on the required rate ( r)
Required rate of return does not vary from one investor to another if applied correctly. One way to compute r is using the Capital Asset Pricing Model. (CAPM) which states.

Required Rate of return=risk free rate + Beta factor(Market return- Risk free rate)
Risk free rate= is the yield of government Treasury Bonds =9.3 (for ten year Bond) http://www.cbsl.gov.lk/htm/english/_cei/ir/i_3.asp

Beta cab be obtained from CSE

Market return is the average return of CSE (ASI) we should not expect the ASI to increase by 100% every year. Suppose 13% compounded return, ASI would be 25,500 in 2021.technically speaking we should get the ASI over a period and estimate the average return (Ex from 2001 to 2010)

If we know the above three facts correctly we can compute the requires rate of a stock. It is obvious when we change one variable in a formula the result can significantly change.

b) likewise the Growth rate can be manipulated as it is dependant on the company hence the overall Justifiable PE can be manipulated

Growth Rate cannot be manipulated. Example if we know the EPS over a period, we can estimate g
Year 1 2
Year 2 3
Year 3 3.5
Year 4 4
Year 5 5

Growth rate = (5/2)1/5=20.11% compounded growth rate.

c) Everyone does not need to accept Justified PE computations; rather this should be done by individuals if they really want to identify the Intrinsic Price Earning Ration of a particular stock, taking to consideration other facts such as market return, systematic risk (Beta), growth in earnings.

Applications of Price multiples for Sri Lankan listed hotles would not be reasonable as most hotels have not reported profits, or history of profits. Rather most hotels are on losses, so we should use some other valuation methods for hotels.

Fundamental analysis should be then main criteria for an investor if he is INVESTING and not trading. If you just run through the CSE you would find all fundamentally strong counters are trading at reasonable prices (Ex, CTC, LLUB, DOCK, COM, NEST). And some still undervalued.
Even for short term if you are not in to trading then you should always consider the basic fundamentals.

SLstock, I tried to explain in depth, Hope the above makes sense. Please post whatever questions you have.

lion wrote:Hi friends, I am visiting this forum after a long gap, as many are sharing there views on individul stocks I would like to share the theory on justifiable PE. There is a wrong consensus among many local investors that the any stock of PE below 10 is undervalued, above 15 is overvalued, and anything in-between 10 -15 is fairly valued.

According to financial theory, the PE which is unique to individual stocks, justified by its earnings, dividend payout, growth in earnings and the required rate of return of investor is known as the Justifiable PE Ratio. The formula is derived from the Gorden Growth Model formula. Using this formula we can estimate the justifiable PE of a stock.

Based on forward earnings, the formula is simply (payout ratio)/(r-g), where r is the required rate and g is expected growth rate.
Example,
CFIN.
Average dividend payout is 11%, thus retention ratio is 89%
r- required rate, assuming 15% ( which can be computed using further financial techniques such as CAPM)
Growth rate-10% (the GDP growth rate is at 8% and assuming the company would be able beat the GDP growth rate)
Justifiable PE=0.89/(0.15-0.1)-17.8 x
Based on theoretical computation CFIN should be trading at a leading PE of 17.8x.
CFIN projected minimum EPS 2011/2012= 25.x4=100
Justifiable PE =100*17.8=1,780.00

CFIN is just an example I was working on, and is not intended to promote the stock.

Its high time the Sri Lankan investors to learn the theories of capital markets if they are to survive and beat the market in the long run. For more information please Google “Justifiable Price Earnings Ratio” you will find enough articles on this.

Please share your thoughts and comments .

Hope article was helpful.

Have a good week ahead guys.

lion wrote:Slstock, was the analysis and working helpful to you?

lion wrote:Slstock, was the analysis and working helpful to you?

lion wrote:Hi Seyon,

The PEG ratio is also a rule of thumb similar to PE ratio, but takes into account the growth factor, Ex. ODEL.
Forcasted EPS=1.80 has a PE of 23 (42/1.80) and looks overvalued, but taking to fact the Growth in Earnings of 30% PEG would be =23/30=0.7667. PEG of 1 is considered fair, and anything less is undervalued, based on PEG ODEL is undervalued in current prices. Same as PE, PEG also is a rule of thumb and does not have mathematical backing

Justifiable PE is different, it is different. I.e. from this we can identify the True PE attributable a a share taking account Dividend Payout Ratio, Growth in Dividends, Required rate of return from the stock taking into account the systamatic Risk etc. This is from mathematical backing and is agreed by scholars to identify a Justifiable PE of a stock.

Regrds.

lion wrote:Slstock, Apologize for a mistake on my behalf, the ratio used for CFIN is wrong, it should be Payout ratio for the numerator rather than Retention Ratio, I have corrected in the DOCK example.
Correct, Growth should be based on Dividend, further we should estimate the sustainable Growth rate of the firm. There is no hard and fast rule to the number of years to estimate “g”. Rather we should correctly identify the sustainable growth rate of the dividends. Which will not vary from one to another if correctly applied.
Like any financial formula and research, errors can be there in estimates, estimating required rate of returns, growth factors, we should be able to justify the numbers rather than blankly applying the formula.
For CTC, I couldn’t get the data required, as they have not published the ten year summary of financial figures, and the earliest annual report available in CSE was 2008, so if you have the numbers, key and compute the ration and see whether it is reasonable.
These are proven formulas, which are in existence for a considerable period of time in the financial markets.

KPMG wrote:I totally agree with the use of Justifiable PE and its computation which described by Lion,
However we should keep in mind that "Beta" is calculated using many assumptions which are unrealistic in practice and CAPM model developed by MM Theory in 1963 and it also made under assumptions.
therefore it is advisable to be caution when u take decision using formula based figures.
happy day

lion wrote:Hi Seyon,

This formula is derived from Gordons, Dividend Growth Model, Which has its own limitation, this Model is appicable to Stable mature dividend paying entities, The dividend policy is clear and related to earnings of the firm, etc, Its not clear as to CARS, whether DPS is correlation to EPS. In situations like this is is prudent to use a more suitable growth rate for Dividends, like the GDP growth rate, as it is unlikey that anyfirm will continue to grow indefinately at a rate higher than GDP.(7% for CARS) By using g, it is assumed that Dividends will grow indefinately at a constant rate of g. Using growth in EPS is not correct.

Regrs

lion wrote:Yes Seyon, Agreed It is a very difficult task to esatimate complex financial ratios to the CSE at this stage.

seyon wrote:

lion wrote:Yes Seyon, Agreed It is a very difficult task to esatimate complex financial ratios to the CSE at this stage.

But this is good effort to educate the investors like us.... Can u just work out the Justifiable PE ratio for JINS and NEST.... If u have time...

Further investment companies like CINV and GUAR will this be suited,as to vale these share, i guess fair value of the assets would be the most suitable... ( I may be wrong)

Keep on posting the good informative stuff.

Happy Trading