Valuation -How to evaluate the PE ratio

January 18, 2008

I had done a quick valuation exercise of MRO-TEK earlier (see here). I used a certain PE ratio in the post and said that I would explain my approach later. So here it goes … 

To understand my approach, you have to look at the file Quantitative calculation and worksheets – cap analysis and ROC and PE.

You can download this file from the google groups clip_image001.gif

The worksheet ‘ROC and PE’ has DCF (discounted cash flow model) scenarios for various businesses such as Low growth, high ROC (return on capital ). For ex: Like Merck or high growth and high ROC like infosys etc.

As you can see, I have put a growth of around 10% in Free cash flow, ROC of 40% and calculated the Intrinsic value (or Net present value). The ratio of the NPV/current earnings gives a rough value of PE for the above assumptions Now I have used various assumptions of growth, ROC etc and created the matrix . See the CAP analysis worksheet –  clip_image002.gif

The above is for a matrix of ROC (return of capital = 15%). I have varied the growth and CAP (Competitive advantage period).

As you would expect, if growth increases, so does the intrinsic value and the PE. If the ROC increases the same happens. This is however ignored by most analysts and sometimes the market too. This is where opportunity lies sometimes. The third variable – CAP also behaves the same. Higher the period for which the company can maintain the CAP, higher the intrinsic value and higher the PE. CAP or competitive advantage period is not available from any annual report or data. It is the period for which the company can maintain an ROC above the cost of capital. For a better understanding of CAP, read this article – measuringthemoat from google groups. It’s a great article and a must read if you want to deepen your understanding of CAP and DCF based valuation approach. 

As I was saying, CAP is diffcult to estimate as it depends on various factors such as the nature of industry, competitive threats etc. I usually assume a CAP of 5-8 years in my valuations. If it turns out to be more than that, then it serves as a margin of safety. Now when I look at the company, I use the worksheet ‘ROC and PE’ and my thought process (simplified) is as follows 

  1. Look at ROC – does the company have an ROE or ROC of greater than 13-14% ? If yes, is it sustainable (this is subjective).
  2. Use the above worksheet to select a specific ROC sceanrio.
  3. What has been the growth for the company in the last 8-10 years. What is the likely growth (again subjective estimates).
  4. What is the likely CAP? This is a very subjective exercise and requires studying the company and industry in detail. If the company checks out, I usually take a CAP of 5-6 years.
  5. Plug the ROC, growth, CAP and current EPS numbers in the appropriate sceanrio and check the PE. That is the rough PE for the instrinsic estimate.
  6. Check if the current price is 50% of the instrinsic value
  7. Cross check valuation via comparitive valuations and other approaches.

 If all the above checkout, it is time to pull the trigger.

 In case the above has not bored to tears, JNext posts: Some conclusions from  table for CAP v/s PE v/s Growth (CAP analysis worksheet), pointers on DCF (boring stuff ??) 

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