Valuation - is the stock overvalued or undervalued?

Finding a great company is just one part of the equation. Buying it at an overvalued price will still give you a poor return. Just because a stock hit a fifty-two week low, doesn’t mean it’s a bargain. In the following section, I will tell you how to measure the stocks attractiveness whether it is overvalued or undervalued but first let’s start by understanding how a stock price is established.

Price = EPS (Earnings per share) * P/E Ratio.

Example:

$20 ABC Stock = $1.00 EPS * 20 P/E

EPS is simply the net income of the past 12 months divided by the number of shares outstanding of the company.

Example:

ABC Company made $20 million this year and has 20 million shares outstanding

$20 million divided by 20 million shares = $1.00 earning per share

The P/E Ratio is a measure of how cheap or expensive the share prices are. The market establishes this ratio. In general, as the stock bids higher, the P/E multiple increases, signaling over valuation. As the stock bids lower, the P/E multiple decreases, signaling under valuation. The P/E Ratio is calculated by taking the price of the stock divided by EPS.

Example

ABC Stock Price $20/1.00 EPS = 20 P/E

Is a 20 P/E high or low? Well it depends on the sector because each sector is different. For instance, homebuilders generally have a P/E range between 5-10. But semiconductor stocks have a P/E range of 20-30. Also it depends on future earnings growth of the company. Strong future earnings growth should demand a higher P/E.

Sometimes a P/E ratio is misleading. Since it’s based on the last 12 months earnings, if there was an unexpected one-time loss or shortfall in earnings, there would be a disparity in the P/E ratio because the rare event. Just realize P/E is just a number to compare with other similar companies and is just a starting point to researching the attractiveness of the stock.

Stock’s Future Price

Now that you know how the stock price is derived, if you knew what a stock would be worth five years from now, it would definitely impact what to buy? Image if you knew the future stock price of Apple or HPQ way back when. You don’t need a crystal ball anymore. Now you can figure it out so long as the company’s past history and future earning prospects are predictable.

Future Stock Price = Future EPS * Conservative Future P/E.

Conservative Future P/E

Now that you know P/E Ratios, we need a conservative future P/E for our calculation. The S&P report shows you each year’s highs and lows for the company’s P/E. Take the average of what you think is a conservative P/E.

ABC stock example:

	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Current Year
P/E high	30	32	20	22	25	50	34	50	40	35
P/E low	20	25	15	17	18	40	21	30	25	22

Unfortunately this is more common sense estimating than and exact science. It would not be out of the question for the future P/E to be 30 but to stay conservative in our prediction; I would choose a P/E of range of 20. You may choose 18 or 22. It all depends on level of comfort or “ margin of safety” which we will discuss later on.

Conservative Future Earnings Growth

Figuring out the earnings growth for the next 5 years is the next step. Why five years? Remember what Warren Buffett said, “Time is a friend to a wonderful business”. If it were a great business, you wouldn’t want to sell it for 1 or 2 yrs but hold it for the long term. And usually it takes time for the market to validate your future target price. Inevitably over the long term, if earnings rise, the stock price will follow.

Internet links:

MSN Money shows earning estimates for 5 years.

Link: http://moneycentral.msn.com

Yahoo! Finance shows the PEG ratio (5yr expected) of a stock but to calculate the earning growth rate, you have to do some math.
Link: http://finance.yahoo.com/

Example

ABC company Stock Price : $20
PEG ratio : 1.00
P/E : 20.00
G (growth rate) : ?

$20 stock price divided by $1.00 EPS equals 20 Growth as a percentage in the next 5 years. There may be a difference between Yahoo!’s earning estimates and MSN’s. After all, it’s just a prediction and not a sure thing. We still have to calculate it ourselves but it’s good to compare our results with analyst to see if we are on the right track.

Calculating Future Earnings Growth

To predict future earnings growth of the company requires using information from the company’s past. And past earnings must be consistent and predictable. If the company makes money one year and loses money the next like a roller coaster, estimating an accurate earnings is near to impossible.

ABC EPS Example

Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Current
0.10	0.15	0.28	0.25	0.35	0.41	0.60	0.78	0.90	1.00

To calculate the compounded earnings growth, you need a compounding calculator. You can easily find one on the Internet.

Internet Link:

Compounding calculator

http://moneychimp.com/calculator/discount_rate_calculator.htm

Compounded rate of return

Yr 1 – Yr 5 : 28.47% (first 5 years)

Yr 5 – Current : 22.22% (last 6 years)

Yr 1 – Current : 25.89% (full 10 years)

Please note that adjustments may need to be made to the EPS to calculate the proper earnings growth. For instance, if the base of year 1 was a penny instead of 10 cents, the earnings growth would be dramatically different and would paint a much more prettier picture of the company’s growth. Conversely, if the current EPS were 10 cents instead of 1.00 dollar, there would be no growth for the company for the past 10 years. So keep in mind, you need to make adjustments based on the earnings trend.

In our example, earnings growth started high at 28% and has slowed to 22% in the last 6 years. A conservative estimate would be 20% growth in the next 5 years.

Calculating Future Stock Price

Now by knowing the future price of the stock in 5 years and based on what the current price of the stock is trading, you can determine if it’s overvalued or undervalued. If you calculate a return of 1-14% return, I would consider it overvalued. If you can calculate a 15%+ return, it’s undervalued and worth purchasing.

By taking the company’s current EPS compounded at the earnings growth rate for 5 years and multiple it by a conservative P/E gives you the future price of the stock.

ABC stock example

$1.00 EPS compounded at 20% earnings growth for 5 years = $2.49 future EPS

$2.49 * 20 conservative P/E = $49.80 future stock price in 5 years.

If the current price of ABC stock is $20, that’s a compounded rate of return of 20.02% for 5 years. Looks like a bargain. Now you can quantify whether a stock is cheap or expensive based on the return you get.

Margin of Safety

Always be conservative in your estimates whether it’s the P/E or the earnings growth or adjustments to current EPS. It’s always better to be ultra conservative than to be too optimistic. Your estimates could be dead wrong and by being conservative, it protects you from major loss. You always need a “margin of safety” in place. Be patient and don’t settle for less until the stock price hit’s the price you are looking to buy at.