January 29, 2008

Valuation - some more thoughts

I covered my approach to estimating the appropriate PE for a stock and reverse engineering the current valuations in the previous posts. This is ofcourse not the approach taken by analysts. The typical approach is to look at the past history and decide on the likely earnings (and not even free cash flow). If the analyst is optimisitic he slaps on a high PE and voila ..we have the price target. To support the argument, the analyst does a comparison with other companies in the sector and tries to justify the PE. So we may have an optimisitic earnings estimate and on top of that a high PE attached to it, which would amount to double counting.

That is an incomplete approach. If the sector is in a bull run or has very high valuation then you are committing the same mistake twice. First assuming an optimistic estimate of earnings and then applying a high PE. Don’t believe me ? …well several IT companies sold for a PE of 100 in 2000 and real estate and capital goods companies sell for similar high valuations. Average PE for IT companies is now below 20 and mid caps in IT sometimes sell for less than 10 times.

This brings me to some interesting observations which you can derieve from this table below


For a company to justify a PE of 30+ the following has to happen – The company has to grow a more than 15-18% per annum for 9-10 years and maintain a ROE or ROC of 15% or higher. That would justify the PE of 30. If a company sells for that PE, then for you to make money the company has to do better than that. PE ratios of higher than 40, require higher growth, higher ROC and much longer CAPs.

Is that likely ? well it can happen …but don’t bet on that. Industries which have high growths and high ROC tend to attract a lot of competiton which drives the returns down. That’s a given rule of economics.

As a result I am wary of companies having a high PE. To justify an investment, the company has do better than the implied value (which you can get from the table above).

Final point – I have put comments on the right of the table with color schemes. Red means stay away for me !

3 comments:

TempleTree said...

Hi Rohit,

I have one question on the P/E vs CAP table.

What is the probability column? Does it indicate the probability of able to estimate value correctly?

Thank you,
Rajani

Rohit Chauhan said...

the probability column is a subjective probability column. you can read it with the color code in the main matrix. so a green color with probability of 0.9 means that a company with a PE of 14 has a high probability of achieving the growth of 12% and maintain a CAP of 3 yrs
On the other hand red and low probability means that a company with a PE of 40 has an expectation of 18% growth and CAP fo 18 years built into the price. That would be a tough hurdle to cross and very few companies would do that.

hope this helps

Anonymous said...

i have seen your web page its interesting and informative.
I really like the content you provide in the web page.
But you can do more with your web page spice up your page, don't stop providing the simple page you can provide more features like forums, polls, CMS,contact forms and many more features.
Convert your blog "yourname.blogspot.com" to www.yourname.com completely free.
free Blog services provide only simple blogs but we can provide free website for you where you can provide multiple services or features rather than only simple blog.
Become proud owner of the own site and have your presence in the cyber space.
we provide you free website+ free web hosting + list of your choice of scripts like(blog scripts,CMS scripts, forums scripts and may scripts) all the above services are absolutely free.
The list of services we provide are

1. Complete free services no hidden cost
2. Free websites like www.YourName.com
3. Multiple free websites also provided
4. Free webspace of1000 Mb / 1 Gb
5. Unlimited email ids for your website like (info@yoursite.com, contact@yoursite.com)
6. PHP 4.x
7. MYSQL (Unlimited databases)
8. Unlimited Bandwidth
9. Hundreds of Free scripts to install in your website (like Blog scripts, Forum scripts and many CMS scripts)
10. We install extra scripts on request
11. Hundreds of free templates to select
12. Technical support by email

Please visit our website for more details www.HyperWebEnable.com and www.HyperWebEnable.com/freewebsite.php

Please contact us for more information.


Sincerely,

HyperWebEnable team
info@HyperWebEnable.com