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FINANCIAL CHRONICLE™ » CHRONICLE™ ANALYTICS » Stock Valuation — EPS Growth - PE Ratio Method

Stock Valuation — EPS Growth - PE Ratio Method

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sriranga

sriranga
Co-Admin
Here's another widely used, useful stock evaluation method. We first project Earnings per Share (EPS) up to a certain point in the future. Next, we use an estimated Price/Earnings (PE) ratio to calculate the future stock price. Finally, we translate that number to the present value to give us the "intrinsic value" of the company.

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.

[You must be registered and logged in to see this image.]

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.

[You must be registered and logged in to see this image.]
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.
[You must be registered and logged in to see this image.]

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



Last edited by sriranga on Sat Feb 11, 2012 1:30 pm; edited 2 times in total

http://sharemarket-srilanka.blogspot.co.uk/

Slstock

Slstock
Director - Equity Analytics
Director - Equity Analytics
SriRanga

You are making some very valuable post to the forum. Thanks you very much. + rep.

BTW isn;t the formula

A = P(1+R) ^N, where
^ is to the powers of N

NOT P(1+R)N means Px(1+R)xN ??


New comers
If you'll remember we can use the same formula to calculate compounded Fixed deposit returns.nbank deposit returns after a period of some years.



A = Current EPS (Amount)
N = Number of years
P = EPS N yrs. prior (Principal)
R = Annual Growth Rate (Interest rate)

Azthama

Azthama
Senior Equity Analytic
Senior Equity Analytic
Very useful article,,Thanks srirangs for sharing Smile

thilankad

thilankad
Manager - Equity Analytics
Manager - Equity Analytics
thanxs bro valuable article

http://thilankadinush.blogspot.com/

sriranga

sriranga
Co-Admin
@slstock wrote:SriRanga

You are making some very valuable post to the forum. Thanks you very much. + rep.

BTW isn;t the formula

A = P(1+R) ^N, where
^ is to the powers of N

NOT P(1+R)N means Px(1+R)xN ??


New comers
If you'll remember we can use the same formula to calculate compounded Fixed deposit returns.nbank deposit returns after a period of some years.



A = Current EPS (Amount)
N = Number of years
P = EPS N yrs. prior (Principal)
R = Annual Growth Rate (Interest rate)


@slstock
Thanks for the valuable comments.

Yes it is the power of N.

Typing error from my part.
My apologies to the readers.

http://sharemarket-srilanka.blogspot.co.uk/

Slstock

Slstock
Director - Equity Analytics
Director - Equity Analytics
@sriranga wrote:
@slstock wrote:SriRanga

You are making some very valuable post to the forum. Thanks you very much. + rep.

BTW isn;t the formula

A = P(1+R) ^N, where
^ is to the powers of N

NOT P(1+R)N means Px(1+R)xN ??


New comers
If you'll remember we can use the same formula to calculate compounded Fixed deposit returns.nbank deposit returns after a period of some years.



A = Current EPS (Amount)
N = Number of years
P = EPS N yrs. prior (Principal)
R = Annual Growth Rate (Interest rate)


@slstock
Thanks for the valuable comments.

Yes it is the power of N.

Typing error from my part.
My apologies to the readers.

No problem. Keep it up Sriranga.

Noticed a "certain" person again using multiple accounts has given me 3 -minus reps for the post.
So logically I am assume 2 things, the - reps are for you not agreeing with me

a) that Sriranaga is not making some very valuable post to the forum
b) the fact I pointed out is incorrect.

I know asking that person to come forward and correct it if it is wrong won;t work as he is not that kind.

So how about more negative reps for this post also?

7Stock Valuation — EPS Growth - PE Ratio Method Empty stock valuation-EPS-p/e ratio method Sun Oct 02, 2011 7:19 pm

dilshanusjp


Senior Equity Analytic
Senior Equity Analytic
Thanks a lot really valuable article Smile

Ben Graham

Ben Graham
Senior Equity Analytic
Senior Equity Analytic
nice post sriranga. +rep from me.

@slstock- compensated ur two - reps. (gave +2reps)

WildBear


Assistant Vice President - Equity Analytics
Assistant Vice President - Equity Analytics
@Ben Graham wrote:nice post sriranga. +rep from me.

@slstock- compensated ur two - reps. (gave +2reps)

Hey Ben, You've got a Very Sexy avatar Very Happy

@slstock, I gave you a + rep too.

Slstock

Slstock
Director - Equity Analytics
Director - Equity Analytics

Thanks WildBear and BenGraham.






wsaman

wsaman
Manager - Equity Analytics
Manager - Equity Analytics
Tnx sriranga....
great work.....

laki


Senior Equity Analytic
Senior Equity Analytic
good

K.Haputantri

K.Haputantri
Co-Admin
Very useful one Shri. Thanks.

KDDND

KDDND
Assistant Vice President - Equity Analytics
Assistant Vice President - Equity Analytics
Thank you Sri! cheers

I am getting a lot n learning lot now I can try predicting a bit with the shares I like Smile

Lots of Home work to do before touch the train! Basketball

K.Haputantri

K.Haputantri
Co-Admin
@KDDND wrote:Thank you Sri! cheers

I am getting a lot n learning lot now I can try predicting a bit with the shares I like Smile

Lots of Home work to do before touch the train! Basketball
You are right. Need to learn more befor you step in. Happy trading.

Quibit


Senior Vice President - Equity Analytics
Senior Vice President - Equity Analytics
Conventional valuation method becomes handy in a market like this.

TARGET


Senior Manager - Equity Analytics
Senior Manager - Equity Analytics
Good topic for learners. Thanks sri and sls. Look how good this forum those days. Any one know where is hapu now? Chinwi any idea?

Chinwi

Chinwi
Associate Director - Equity Analytics
Associate Director - Equity Analytics
Mr Haputantri ( his used his real name ) was active in the other forum sometimes back.

I have no idea where is he now . I met him once in lifetime , lost contacts thereafter.

Sriranga (Mr K) is active always, doing a grate job.

TARGET


Senior Manager - Equity Analytics
Senior Manager - Equity Analytics
@Chinwi wrote:Mr Haputantri ( his used his real name ) was active in the other forum sometimes back.

I have no idea where is he now . I met him once in lifetime , lost contacts thereafter.

Sriranga (Mr K) is active always, doing a grate job.

thanks chinwi for the information. Mr Haputantri is a real gentleman. I have to tell you another important thing attached to this. But it can't be disclosed publicly. Since pm is not working here if you can send me a email on this
"targetred101@gmail.com

Chinwi

Chinwi
Associate Director - Equity Analytics
Associate Director - Equity Analytics
do you know my email ? sometimes back I gave it to few ppl.

Otherwise some other person can mimic .

about hapu: I had his card. I may search .

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