Reading 44: Company Analysis and Stock Valuation

This reading is a small one and took me only around 45 minutes. The first part is a repetition and re-introduces the concept of franchise P/E.

Intrinsic P/E= Base P/E + Franchise P/E

Franchise P/E= FF*G, where FF= (ROE-r)/(ROE*r) and G= g/(g-r)

There is a new concept in this Reading, called the Growth Duration Model, which basically states that the ratio of the P/Es of a high growth and a non growth stock should be proportional to their composite growth rates. The growth estimate must consider both the rate and how long this growth rate can be sustained- that is, the duration of the expected growth.

ln (P/E (g): P/E (a))= Tln(1+dg+gg)/(1+da+ga)

The numerator is the P/E and the composite growth rate of the growth stock and the denominator is the P/E and the composite growth of the non growth stock.

dg and da= dividend yield of the growth and the non-growth stocks

gg and ga= growth rate of the high growth and the non growth stocks.

T= the number of years for which the growth stock needs to have above average growth rate in order to justify the high P/E ratio.

From the Gordon Growth Model, r= Dividend Yield (D/P)+ Capital Gains Yield (g). So, the denominator can be reduced to (1+r). Keep that in mind.

So, if the implied growth rate according to the model is greater that what you believe is reasonable, then we would sell that stock. On the other hand, if the implied growth rate acc. to the model is less than what you believe is reasonable, then you would buy that stock.

Factors to Consider:

1. We use the expected rate of growth.

2. Technique assumes equal risk and equal payout ratio.

3. This technique assumes that stocks with higher P/E have the higher growth rates. However, this might not be true. High P/E stocks might have low growth rates and vice versa.

This inconsistency between the P/E and the growth rate might occur due to several reasons-

a. Major difference in the risk involved

b. Inaccurate growth estimates- The higher P/E stock might have a higher growth rate and the lower P/E stock might have a lower growth rate.

c. If the higher P/E stock has a lower growth rate, then it is over valued. (Consider a. and b. before considering c.)

d. If a low P/E stock has a high growth rate, then it might be under valued. (Consider a. and b. before considering d.)

So, the results of our modeling will only be as good as our assumptions and other data inputs.