One of the quickest ways to check how highly valued a stock is, is to look at its price-to-earnings ratio (P/E), also known as an earnings multiple.
The earnings multiple is the stock price divided by earnings per share (EPS), and the units are expressed in years- how many years of those earnings it would take to equal that stock price.
For example, if a stock is $50, and its EPS is $2.50, then the earnings multiple is 20. The stock price is expressed in dollars, the EPS is expressed in dollars per year, so the earnings multiple of 20 is expressed in years- it would take twenty years of $2.50 each year to get $50.
Of course, the earnings multiple alone doesn’t tell us much. If the company is growing its EPS each year, then in reality it will take less than that number of years for cumulative EPS to sum to the current stock price. Therefore, what constitutes a “fair” earnings multiple depends on several factors like growth and stability.
Proving a Fair Earnings Multiple
Often, earnings multiples are just used to compare two companies within the same industry, or used to compare for the same stock at two different points in time. It can also be used to check the valuation of the entire market, like with the Shiller P/E ratio.
However, using other valuation methods like the Dividend Discount Model or Discounted Cash Flow Analysis, you can determine an intrinsically fair stock price for a company, based on expected future profitability and a target rate of return. Playing around with those valuation methods, and checking the P/E ratios of those calculated fair values, provides an investor with experience about what earnings multiples are fair compared to certain amounts of growth and stability. Once an investor has that intuitive understanding, it’s easy to do back-of-the-envelope calculations about stocks, easy to look at an earnings multiple, expected growth, and have a reasonable estimate of how fair is, etc.
The Earnings Multiple Valuation Approach
Having an intuitive understanding of what constitutes a “fair range” of earnings multiples for a stock, relative to stability and expected growth, allows an investor to calculate some scenarios about future stock price. This method can serve as an alternative to doing Discounted Cash Flow Analysis, and can be used whether or not the company pays a dividend.
The method is to estimate EPS growth over a period of years, then place a hypothetical earnings multiple on the EPS figure at the end of that period, and compare that hypothetical stock price to the current stock price, which can allow for quick calculation of expected rate of return over that period. There are three components to the final value:
1) The final stock price at the end of the period.
2) Cumulative dividends received over that period.
3) The impact of cumulatively reinvesting those dividends.
Suppose a railroad company, called “DM Rail” currently has EPS of $2, pays annual dividends of $1, and has a stock price of $40. Since 40/2 is 20, the earnings multiple is 20.
You think that’s a little bit high, would rather see a lower earnings multiple, but decide to look at the track record of growth along with future company plans to make a 10-year estimate. Based on previous growth, management goals for EPS growth, explanations of how they’ll reach those goals, and other factors, you estimate a 10% rate of EPS growth over the next ten years, and assume that the dividend payout will stay the same, so the dividend also grows by 10% per year.
The table of growth would like something like this:
The numbers of Year 0 are the trailing twelve month period that you’re looking at, so the holding period, if you buy the stock, would be years 1-10 (for a ten year holding period).
You believe that the earnings multiple is a bit rich currently, but feel that the company has this fairly strong growth ahead, and would like to simulate what would happen if, over time, the market decides to lower the earnings multiple of the stock. You assume an earnings multiple of 16 is fair.
Ten years from now, if the company grows as expected, EPS will be about $5.19, and 16 * $5.19 = $83.04. That’s the estimated stock price 10 years from now, but we still have to take into account dividends.
The cumulative dividend value over that ten year period (year 1 through year 10, just adding up ten years of dividends) was $17.52, which was calculated with a simple spreadsheet. But, assuming we didn’t just collect dividends and leave them in an account, and instead reinvested them somehow (either back into the stock or into another investment), then those dividends have a time value and made more money during the decade, which we now have to take into account.
We can say, roughly, that dividends can be invested for an 8% rate of return, which is close to and a bit under the S&P 500 average rate of return, just to be on the conservative side. Assuming that, then these dividends, calculated with a fairly straightforward spreadsheet formula, mean that an additional $6.38 was generated over this period due to the money made from reinvesting those dividends. That calculation assumes dividends were reinvested annually- assuming a quarterly reinvestment rate will change the value by a few extra pennies.
If you’re not using a spreadsheet, and you want to also use an 8% assumed rate of return for the dividends over a ten year period, then you can say that the amount generated from reinvested dividends was about a third of the total cumulative dividend value (in this case, $6.38/$17.52 = 36%). So, that’s just a quick shortcut. Rather than calculating the effect of reinvested dividends each time, if you’re assuming an 8% rate of return and a ten year period, you can just take cumulative dividends, and then add another 1/3rd of the cumulative dividends which represents the reinvested value of those dividends.
So, the total value at the end of this period is:
(Final Stock Price) + (Cumulative Dividends) + (Value From Reinvested Dividends)
Using the shortcut, it’s just:
(Final Stock Price) + (1.33 * Cumulative Dividends)
In this example, using the longer method, the final value is:
$83.04 + $17.52 + $6.38 = $106.94.
This means that over this ten year projected period, $40 turned into $106.94, which translates into an annualized rate of return of 10.3%, even though the earnings multiple dropped from 20 to 16. This simulation can be run in various ways for different rates of EPS/dividend growth, different final earnings multiples as assigned by the market at that time, in order to determine a range of scenarios that might happen. This can give you an idea of what some poor scenarios are, as well as some fair scenarios or particularly bullish scenarios.
Finding the right stock value before making a purchase
As you can see, determining the entry point of a stock is not easy. The one product I offer on this site is the Dividend Toolkit, which is a comprehensive stock guide that also comes with an easy-to-use valuation spreadsheet to calculate the fair price for dividend stocks. The book along with its spreadsheet will save you time and simply your stock valuation method. You will also find complete information on how to use the calculation table in order to buy stocks at a fair or bargain value.
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