Many investors attempt to determine a stock’s worth by simply viewing it as a multiple of a company’s earnings. This is the basis used for calculating the P/E ratio for any company’s stock. But once calculated, what determines the appropriate ratio? Many investors compare individual company’s P/E ration to the P/E ratio of a market average, like the DJIA or the S&P500. If the company’s P/E is larger than the market’s P/E, then the price of the individual stock is overpriced. But this is too simple and really doesn’t take into account the differences in individual companies.
A review of several different company’s P/E ratio will quickly show that the ratios of different companies differ greatly. That’s because investors value different companies differently. Companies that grow earnings at a faster pace are often considered more valuable and hence, are priced higher. The result is a higher P/E ratio. Companies that grow earnings at a slower pace, on the other hand, are often priced lower resulting in a lower P/E ratio.
Since earnings growth rates often vary slightly from year to year for most companies, I tend to look at a company’s expected growth rate over the next five years. While that’s only an estimate, it’s a smoothed or averaged expectation of upcoming earnings increases. I then use that earnings growth rate as my expectation of where the P/E ratio of any given company will gravitate toward over time. I then calculate a company’s value as a relationship between a company’s earnings growth rate and it’s stock price.
So in the process of trying to determine a company’s true worth, I tend to multiply a company’s five year earnings growth rate by a company’s next year estimated earnings per share to determine the value of the company one year into the future. From this it’s simply a comparison of next year’s expected price divided by the current price to determine the percentage increase over the next year. If that increase meets my minimum requirement, then that company becomes a possible candidate for accumulation.
The next thing I do is check to see if the company has a rising dividend. If not, then it’s discarded. If it does, I check to see just how many years its been increasing, and obviously the longer the better. I also check to make sure that the payout ratio is less than 100% because any company paying out more than that can not possibly continue to pay a dividend for long.
I also sort my list of candidates for companies that have a quick ratio greater than one and a current ratio greater than one. If either of these are below one the chances of the company paying a dividend for very long are slim since the company’s assets are less than its liabilities.
The last couple of checks involve looking at the debt to equity level to ensure that there’s more equity than debt, for obvious reasons. And ensuring that there are expected positive earnings in the next year and the next five years. Once I sort through all those requirements, I generally have a nice list of companies that I expect will have a higher price next year as well as a growing dividend.
My final comparison is between the one year expected price, as calculated above, with the one year target price as calculated by a number of analysts. If they’re similar, I have a lot of confidence in both my calculation and the analysts’ conclusions. If they’re not, I investigate further to try to determine which number is correct.
I’m sure others have dozens of different ways of estimating the value of a company’s stock but this is how I do it. I realize that a lot of the numbers I use are calculated guesses and assumptions, but when you’re dealing with the future no one has the facts. Only assumptions.
In the end, I’m just looking for the best possible investment I can find. That’s why I calculate these numbers over and over and over again. They’re estimates and they can change over time, as all estimates will do. And then I compare them to each other in order to buy the shares of the best company I can find.