What are methods of comparables
When you value a stock based on the average price multiple of the stock of similar companies
What is the method of forecasted funadementals
Values a stock based on the ratio of its value from a DCF to a fundamental variable
Why should we use a P/E ratio?
Earnings power are the best determinant of investment value
It is popular in the investment community
Empirical research shows that it is related to long run avg stock returns
What are drawbacks of P/E ratio
EPS can be zero and then P/E would not make sense with a small denominator
Hard to distinguish repeatable earnings which are key for intrinsic value frpm one off components
Difference in accounting standards can make it hard to chose acceptable alternatives
What is the difference between Trailing and leading (forward) PE
Trailing P/E = Stock Price / Current EPS
Leading = Stock Price / Next years expected EPS
What is a normalized PE
P/E based on a long run expected average EPS factor
What should analysts do when determining Trailing EPS?
Look for dilution in EPS
Look for nonreccuring components
Look for differences in accounting methods
What should analysts do for Business Cycle influences?
Normalize EPS - estimating the level of EPS that the business could be expected to achieve under mid-cyclical conditions
Normalised can be also refer to earnings adjusted for noreccuring items
How do you calculate normalized EPS?
Method of historical average EPS - EPS is calculated as average EPS over recent economic cycle (lasting multiple years)
EPS = average return on equity from the most recent full cycle multiplied by current BVPS
What should you do when P/E is negative? e.g. the company is losing money
Use E/P (earnings yield) - the misbehaving number (earnings) is now in the numerator and the normal number (price) is in the denominator - so it wont
How can you show the justified Forward P/E
P/E = D/E (Dividend Yield) / r - g or 1-(retention rate) / r-g
How can you show the justified Trailing P/E
D0(1+g) / E / r-g = (1-retentation rate)(1+g) / r-g
What is a PEG Ratio?
P/E to growth ratio
= P/E / expected earnings growth rate (in percentage terms)
It is meant to show P/E per unit of growth - Lower PEG means you’re paying less for each percentage point of growth
What are the issues with PEG Ratios
It assumes a linear relationship with growth rate e.g. if youre paying 2 of P/E per 1 of growth then a stock growing at 10% should have a P/E of 20, but g is in the denominator of justified PE and the relationship is not linear
Ignores risk which is a determinant to P/E - could have a lower required return
Does not account for duration of growth - does not tell you how long the growth will last
It also does not account for overall growth rate of an industry of economy as a whole
How to calculate terminal value using P/E
Terminal value from period N
Take gordon growth model of terminal value(n) = Dividend(n+1) / r-g
Divide by Earnings of year N = Dividend(n+1)/Earnings(N)/r-g
How does a P/E multiple act in a recessiona and economic boom
Becuase Earnings swing with the economy, yet prices are based on investors expectation so they’re relatively stable - P/E can be super high during a recession and super low during growth
