The logic behind the use of “Absolute PE of stocks” to estimate its intrinsic value is pretty simple.

We all know about the utility of conventional PE ratio to value stocks.

Market Price = *Conventional PE* X Earning Per Share (EPS).

The same formula we can use to estimate Intrinsic value of stocks.

Intrinsic Value (IV) = *Absolute PE* (A.PE) x Earning Per Share (EPS).

Though this formula may look simple, but trick lies in how to calculate Absolute PE of stocks.

The purpose of this article is to make my readers grasp the concept of absolute PE.

My **stock analysis worksheet** already does this difficult calculation of absolute PE for its readers.

But this blog post will further explain, what calculations are involved in the back end to arrive at a final absolute PE for a stock.

## Why one must care to know how to calculate absolute PE?

This is a very valid question.

A person who wants to base his stock investment decision based on Absolute PE model must know about its reliability.

The reliability of absolute PE comes from the detailed calculation that goes behind it.

Though the formula of Absolute PE is simple (shown above), but it encompasses following business parameters to arrive at a near accurate intrinsic value:

**Base PE**(applicable for all stocks).- Points Earned due to:
- Future
**earning growth**potential of stock. - Historic
**dividend yield**power of stock.

- Future
- Multiplying Factor due to:
**Business risk**associated with the underlying business.**Financial risk**associated with the underlying business.**Future profit predictability**of the underlying business.

What is the logic?

Each stock has its own character.

A stock whose “earning” is growing fast enough can demand higher PE (more than base PE) and vice versa.

Stocks which yields good “dividend” can also demand higher PE (more than base PE) and vice versa.

A stock whose associated “business and financial risk” is higher deserves lower PE (than base PE) and vice versa.

A company which is generating very “consistent profits” can afford to demand higher PE (more than base PE) and vice versa.

What does this mean?

It means, each of these five (5) individual factors mentioned above (earning, dividend and risks) has some *positive or negative influence* on its base PE.

In the process of calculation of absolute PE, each of these five factors are evaluated, and accordingly a **justified PE ratio** is figured-out about each stock.

How these five factors are evaluated?

This is done based on the numbers indicated in the companies financial reports.

Lets see how its done…

### #1. How Points are Earned by the stocks?

Vitaliy Katsenelson in his book *Active Value Investing* has detailed how to calculate Absolute PE of stocks.

The procedure of points allocation is also indicated in his book.

But in my** stock analysis worksheet** a slight deviation is maintained to ease out the procedure, suiting Indian audience.

Anyways, lets first look at the procedure of points allocation used in the worksheet.

#### #1.1 Earning Growth Table

The earning growth table indicates how much *PE points* a stock earns due to its EPS growth potential.

As per this table, a stock with EPS growth potential of 1% will have its PE point of 8 (this is base PE).

If a stock has EPS growth potential of 2%, it will have its PE point of 8.85 (0.65 point more than the base PE).

Similarly, a stock which has EPS growth potential of 3% will have its PE point of 9.3 (0.65+0.65 point more than the base PE).

This increment of **+0.65 points** happens with every 1% increase in EPS growth potential till 16%.

If a stock has EPS growth potential of more than 16% p.a., the increment will be **0.5 points** for every 1% increase.

##### Example:

Suppose a stock (“**ABC**“) which has EPS growth potential of **13.9%** per annum, what will be its PE point?

See the above table and try to answer yourself.

The correct answer is **15.8** and not 16.45.

This is how Vitaliy Katsenelson has asked us to allot PE points for EPG growth.

But how to know the future EPS growth potential of a stock?

The easy answer will be to calculate 5 years EPS CAGR of the stock, and assume the same growth rate to continue for future.

But in the real world, EPS growth is dependent on several factors of a company. Some are as below:

- Reserves growth
- Sales growth
- EBITDA growth
- Net Profit growth etc

The *interdependence* between EPS growth and other factors can be very deep rooted and intertwined.

Hence in my **stock analysis worksheet** I have limited the factors to the above four only.

I have assumed that, median of growth rates of all above four factors gives us the real future EPS growth potential of a stock.

[P.Note: It better to stay defensive when we have to forecast future stock performance. Why? Its not in our control. ]

#### #1.2 Dividend Yield Table

The dividend yield table indicates how much *PE points* a stock earns due to its potential to yield dividends for its investors.

As per this table, a stock with dividend yield of 0.1% will have its PE point of 0.1 (0.1 + the base PE calculated in #1.1).

If a stock has dividend yield potential of 0.2%, will have its PE point of 0.2 (0.2 + the base PE calculated in #1.1).

Similarly, a stock which has Dividend Yield potential of 2.1% will have its PE point of 2.1 (2.1 + the base PE calculated in #1.1).

This increment of +0.1% happens with every 0.1% increase in Dividend yield potential.

##### Example:

Suppose a stock (“**ABC**“) which has Dividend yield potential of 0.65% per annum, what will be its PE point?

See the above table and try to answer yourself.

The correct answer is 0.65.

It means, the total points earned by the stock “**ABC**” is as follows:

- Future earning growth potential of stock (PE=15.8).
- Historic dividend yield power of stock (PE=0.65).
**Total PE Point**=**45**(15.8+0.65).

Lets call the total PE point earned above as the *Basic PE (16.45)**.*

### #2. How to deal with the “Multiplying Factors”?

This is where the real number crunching happens.

One needs to pick-up relevant numbers from the companies financial reports to arrive at a right conclusion.

What we are doing here?

We are find answers to the following questions:

**Business Risk Multiplier (BRM)**: How risky is the underlying business for its investors?**Financial Risk Multiplier (FRM) :**Does the financial health of the company pose some risk for its investors?**Future Profit Predictability (FPP)**: Earning CFuture earnings of the company is predictable?

Each of these questions needs answering to arrive at a right conclusion.

What is the objective?

The objective is to use this “multiplying factors” to adjust the above derived PE points (in #1).

How to adjust?

By use of this formula:

Absolute PE = Basic PE x BRM x FRM x FPP

#### #2.1 How to calculate Business Risk Multiplier (BRM)

BRM = [1 + (1-Business Risk)]

What is business risk?

According to investopedia, To estimate the risk associated with a business, one has to look into its historical “sales” and “EBIT” figures (last 5 years minimum).

The standard deviation of a set of data (of sales and EBIT) will quantify that how risky is the business.

To judge the business risk associated to a particular company, my **stock analysis worksheet** looks at its following historical figures:

- Total Income (last 5 years).
- EBIT (last 5 years).
- Net Profit-PAT (last 5 years).

Calculating the average standard deviations of income, EBIT and PAT; and comparing it with a *market standard* gives a clear idea of the business risk associated with the company.

Market standard can be like Standard Deviation (SD) of Sensex, SD of BSE 500 Index, SD of Top Stocks etc.

##### Example:

Suppose, our stock “**ABC**” earns a Business Risk Factor of say 0.78, then its BRM will be as below:

*BRM = [1 + (1-Business Risk)] = [1 + (1-0.78)] = 1.22*

[P.Note: The higher will be the business risk, lower will be the Business Risk Multiplier. This results in lower Absolute PE. Means, lower intrinsic value]

#### #2.2 How to calculate Financial Risk Multiplier (FRM)

FRM = [1 + (1-Financial Risk)]

What is financial risk?

It is the risk associated with the company, for its investors, due to its financial structure.

What financial structure? Like high debt, low liquidity etc.

The debt burden of the company and its current liabilities pose as a major financial threat to any company.

A company which is not able to pay its current liability is at a financial risk.

Similarly, a company which is not able to pay back its loans (debt) is again at a financial risk.

My **stock analysis worksheet** uses the following ratios to judge the degree of financial risk that looms at a company:

- Current Ratio (of last 5 years).
- Debt-Equity Ratio (of last 5 years).
- Free Cash Flow to Debt Ratio (of last 5 years).

A company which has sufficient current assets to pay all its current liabilities is safe.

When a company is carrying low debt relative to its equity base, is safe.

A company which is able to generate enough Free Cash Flow compared to its debt base, is considered safe.

##### Example:

Suppose our stock “**ABC**” earns a Financial Risk Factor of say 0.65, then its FRM will be as below:

*FRM = [1 + (1-Financial Risk)] = [1 + (1-0.65)] = 1.35*

[P.Note: The higher will be the financial risk risk, lower will be the Financial Risk Multiplier. This results in lower Absolute PE. Means, lower intrinsic value]

#### #2.3 How to calculate Future Profit Predictability (FPP)?

FPP = [1 + (1-Future Profit Predictability Risk)]

What is future profit predictability risk?

A company whose future profit looks uncertain, pose a threat to its investors.

Suppose, in the past, the PAT & EPS growth of a company has been very volatile. Such companies will always be looked upon by the investors will lot of scepticism.

Investors would not pay a high price to buy such stocks.

To take a prudent judgement about the companies future profit predictability, it is advisable to also look into companies profit margins.

Companies which are able to *maintain* its margin are more likely to duplicate its present earnings in future as well.

When we are talking about profits, we cannot afford to talk about notional profits. We must take into consideration the actual cash flow.

With these theories in mind, my **stock analysis worksheet** consider the following financial parameters to estimate the future profit predictability risk of a stock:

- Operating Margin.
- Net Profit Margin.
- Cash from Operations.

##### Example:

Suppose our stock “**ABC**” earns a Future Profit Risk Factor of say 0.8, then its FPP will be as below:

*FPP = [1 + (1-Future Profit Risk)] = [1 + (1-0.80)] = 1.2*

[P.Note: The higher will be the financial risk risk, lower will be the Financial Risk Multiplier. This results in lower Absolute PE. Means, lower intrinsic value]

## Conclusion

Absolute PE = Basic PE x BRM x FRM x FPP

What will be the absolute PE for stock “ABC”?

- Basic PE = 16.45
- BRM = 1.22
- FRM = 1.35
- FPP = 1.20

Using the above formula:

Absolute PE = 16.45 x 1.22 x 1.35 x 1.2 = 32.51.

*IntrinsicIntrinsic Value (IV) = Absolute PE (A.PE) x Earning Per Share (EPS).*

If current EPS (TTM) of “ABC” is say Rs.10, its intrinsic value as per absolute PE model will be 32.51 x 10 = Rs.325.1 per share.

##### Quick recap

- EPS Growth Rate: High. Absolute PE: High. Intrinsic Value: High.
- EPS Growth Rate: Low. Absolute PE: Low. Intrinsic Value: Low.
- Dividend Yield: High. Absolute PE: High. Intrinsic Value: High.
- Dividend Yield: Low. Absolute PE: Low. Intrinsic Value: Low.
- BRM: High. Absolute PE: High. Intrinsic Value: High.
- BRM: Low. Absolute PE: Low. Intrinsic Value: Low.
- FRM: High. Absolute PE: High. Intrinsic Value: High.
- FRM: Low. Absolute PE: Low. Intrinsic Value: Low.
- FPP: High. Absolute PE: High. Intrinsic Value: High.
- FPP: Low. Absolute PE: Low. Intrinsic Value: Low.

When Current Market Price < Intrinsic Value, the stock becomes a good buy.

If the calculated intrinsic value is too low below its current market price, buying opportunity diminishes for investors.

When the calculated intrinsic value is above the current market price, it gives a good buying opportunity to its investors.

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