Great question @DrPete

There's a lot of thumb sucking and hand waiving with PEs, and it's hard to come at it objectively. I really like the approach you've outlined.

A few years back I wrote a piece on it trying to tie PEs to a DCF view of value.

https://strawman.com/blog/finding-value-with-the-humble-p-e-ratio/

Tbh, I forget some of the exact assumptions I used in building that table, and the interest/discount rates used would have a big impact.

Hope it helps though.

All good points.

The humble PE is just a heuristic, and like all heuristics it has its limitations.

I just think it's helpful to have something to benchmark price to.

Although it can be quick and dirty, so long as you're using an EPS that has some bearing on reality, and you have some sense of future growth, you can do far worse.

Worth remembering that the PE is just the inverse of the earnings yield. And that can be a more intuitive way to think about it.

So if reported earnings bear some relation to what Buffett calls "owner earnings", and so long as those earnings are reasonably reliable, it's true to say that the higher the earnings yield, the better the investment.

There's no problem if the yield is low, it just means you need to have some conviction that earnings are going to grow enough in the future.

Of course, at the end of the day, value is in the eye of the beholder :)

Hi @DrPete. it’s always nice to come up with something simple that works. However, I think your formula would tend to overvalue low growth businesses and undervalue high growth businesses. Why? Because part of the earnings are reinvested and compounded. Dividends are the portion of earnings extracted from the business and are not compounded. For businesses with ROE lower than your required return rate (RR), say 10% RR and ROE 7, you are better off with all the earnings paid as dividends. For businesses with ROE much higher than your RR you are better off when the earnings are reinvested into the business, providing the ROE is sustainable.

When high growth is reinvested the compounding is extraordinary, which is why you can’t simply add it to your PE formula the same as you can the dividend. @Strawman demonstrated this is his table. You can also play around with different growth rates in a compound interest calculator.

The total future cash returns are either accounted for through reinvested earnings or dividends, so I’m not sure why you add 5, other than to make up the difference. I suspect this should be accounted for in the reinvested earnings component giving more to higher growth businesses.

Currently I prefer to use McNiven’s formula for valuation which considers all these things.

As a cross check I might use historical PE x forecast earnings, however this assumes the business will perform the same in the future as it has in the past, and adjustment might need to be made to the PE if not. Integrated Reseach (IRI) is an example of a business where it was dangerous to assume historical PE for future earnings. ROE fell from 40% to 30% to 10%. It was caned, not only because of falling Earnings but also lower PE (PE x E).

I’ve just finished reading Rule#1 by Phil Town. He uses PE = 2 x historical annual equity growth (which should be similar to ROE when all earnings are reinvested). This would put Strawman’s 50 PE for annual growth of 25% in the same ball park.

As Strawman pointed out, these are all heuristic tools to help estimate the performance of a business 10 years into the future. And as for any great modelling tool, garbage in = garbage out! :)

Cheers,

Rick

Thanks @Strawman @CamSmedts34 @slymeat @Rick for your valuable replies. Here are my reflections after spending a couple of hours playing with DCF models (please don't judge me for how I spent my Sunday afternoon while my family was out - although I did do the Sutherland to Surf run this morning with my eldest daughter, so I'm not a complete failure of a father/husband):

1. @Rick yep, agree, my previous rule of thumb underestimated acceptable PEs for high growth companies. Probably a consequence of my past bias towards larger more stable companies. That's the reason for my post, because I recognised I need to improve the way I valued riskier faster growing companies.
2. @CamSmedts34 @slymeat @Rick yep, agree, earnings can be misleading. The way that I think of "earnings" when valuing a company is normalised/realistic earnings, which is essentially the same as normalised/realistic cash flow. So it's what I think is their genuine earnings/FCF, rather than headline figures the company may use or misleading short-term figures in their accounts.
3. Your table was great @Strawman. From my calculations, looks like you used a discount rate of 10%. Which begs the question of whether that is appropriate for risker faster growing companies? My understanding is that venture capital and private equity would typically be looking for 15-20% return from many of the smaller companies that get attention on Strawman. When I ran DCFs with 15% discount, rather than 10%, it essentially halved the PEs in your table (eg, using a discount of 15%, growth of 20% fits a PE of 25, and growth of 30% fits a PE of 50). Feels to me that the higher the predicted growth, on average the company risk will be higher, and on average a higher discount rate needs to be applied (of course, lots of exceptions to this rule).
4. @Rick and @CamSmedts34 I take your points about more sophisticated valuation models. If I'm trying to squeeze out a couple of extra percent return from my portfolio I'd definitely look for better models. Or if I was looking to invest heavily, your models highlight many of the additional financials that need extra attention. Which highlights for me that different models are needed for different purposes. My purpose for my PE rule-of-thumb is to give me a tool I can use in my head for screening stocks. Or I also use it to apply to a terminal value typically in 5 years, with a more detailed growth, earnings and risk calculation for the first 5 years of the valuation, in which case the formula for the terminal value is relatively less important.

So, after playing with a bunch of DCF models using different growth rates and discount rates, I've modified my PE rule-of-thumb to:

PE = 5 + dividend + (1.5 x growth)

It's a smidge more complicated then my previous rule, but better accommodates riskier faster growing companies. There are of course lots of limitations to this model. But for now at least, I think it meets my need for an easy to use tool for quick screening and terminal values.

Hi Rick, how to you approach McNiven’s formula’s reliance on equity per share with (for example) tech companies whose equity is in intangibles or perhaps drastically over/understated?

Hi @jimmybuffalino, that is a very good question, and something I’ve thought about a lot.

For my calculations I use the Shareholder equity value per share provided by Commsec (ie. Shareholder equity / Shares outstanding). In context with this I think it’s important to look at 5 years of historical ROE performance and equity values for trends.

Your question has also prompted me to reread parts of ‘Market Wise’ to confirm what McNiven says about this. I think the section on ‘Intangibles’ below explains this quite well (pages 80-81).

McNiven points out below that if intangibles are overstated, this increases the equity and therefore decreases the ROE for the same earnings. In the extreme example McNiven provides below, overstating intangibles actually decreases the valuation of the business.

If the business writes off overstated intangibles, this needs to be recognised in the five-year performance of the business earnings, and once considered the correction to the performance of the business (Revised lower ROE) results in the same valuation as when the equity was overstated.

I hope this helps.

cheers

Rick

Benjamin Graham’s Intrinsic Value formula says:

Intrinsic value = EPS × [(8.5 + 2G)]

That means PE = 8.5 + 2G ( Where G is the growth rate)

So for a company with 0 growth, you would be happy to get your capital back in 8.5 years.

@DrPete Your formula could also add a fudge factor for market/business related sediments/factors for the given business you are valuing.

For example, a retailer never attracts a premium to the market compared to a SaaS business. So you might determine that a retailer gets a -3, while the sexy SaaS business gets an extra +5.

You could account for other factors as well like the market cap of the business, if you have a very small market cap, institutional buyers won't be there so you can't expect a premium compared to a large company that attracts the capital of these players. The risk of losses from the investment could also be considered.

These figures would all be guesses but they help me when trying to figure out what a fair PE is for a particular company that I am trying to value. Ie does this company deserve a bit of a premium or discount compared to the market average PE.

Thanks @Rick - that’s a very good and useful answer. I think I’ll have to pick up a copy.

You are very welcome @jimmybuffalino.

Your question has helped me to clarify this in my own thinking. There is a saying, “the best way to learn is to teach someone else!” This is so true!

Cheers

Rick

Hi @Valueinvestor0909, I’m wondering how many investors still use Benjamin Graham’s equation for growth stocks - ie: Value = current normal earnings x (8.5 + 2 x expected annual growth rate)?

Brian McNivan includes it in his section on ‘Popular Myths and Other Nonsense’

McNiven says the equation does not consider dividends, and assumes all growth is positive. He also points out that if you were to value a $100 bond with a cumulative coupon of 8%, the bond would be valued at $196 using Graham’s equation. See below: