Handout for Power Point #4

SSG - Sections 3,4&5


This is a compilation of quotes from the I-Club-List.  Enjoy!


Section 3: P/Es


P/E (price divided by earnings) represents the number of times earnings that people are willing to pay for a stock.  In other words, it’s the number of dollars people are willing to pay for one future dollar of earnings.   Therefore, a P/E of 10 suggests that people are willing to pay $10 for every $1 of future earnings.  Over the life of a company, the higher the growth, the higher the P/E will be. As the company’s growth slows, so will the P/E descend.  Periods of high growth will have consistently high P/Es.


Outlandish P/Es are typically caused by one of two things: abnormally low earnings reported after the high price has been recorded for the year, or “irrational exuberance” on the part of investors who are paying excessively for earnings.


To help determine which ones to eliminate when it’s too close to call, plot the P/Es on a linear graph.


Inflated high and low P/Es, when not removed, affect the high price.  To be more conservative, we can use the "5-year average P/E" instead of the estimated high P/E in Section 4A.


I take a look at the history of actual P/E ratios. If I'm using datafiles, I'll check the PMG front page for sixty months of P/E behavior. 


After you eliminate the Section 3 outliers to get the high and low P/Es, replace them. They will skew the RV and Projected RV.


Section 4: High Price


Obviously, our choices for high price include EPS from:

our 5-year projection x most recent year;
our 5-year projection x most recent 4 quarters;

our 5-year projection x next 4 quarters; or
EPS based on pref. procedure.

I'm leaning toward looking at all 4 options and picking the most conservative


Compare past growth rates for the company with the past P/Es.  This would get you an average PEG (P/E divided by growth rate) for the company, which you can use to project the future high P/E based on your estimated growth rate. 


For years, the premise was not to estimate the high P/E any higher than the rate of earnings growth.  In light of this long bull market, many are now moving that estimate to 150% of the growth rate.  So, if the company has an estimated earnings growth rate of 15%, the estimated high P/E should not exceed 22.5. (15% x 1.5 = 22.5)


In no case would you forecast a high P/E above 30.


Low Price:


In Toolkit, the default low price is based on the average low P/E times the last full year's EPS. An option is using our selected low P/E times the most recent 4 quarters because it’s timely and factual.


Look at the lowest P/E ratio in Section 3, column E and multiply the TTM [trailing twelve month] EPS figure for a "worst case scenario" low price.


To be on the safe side, let the earnings for the most recent four quarters represent the lowest future earnings.  For a growth stock, zero earnings growth in the next 5 years would be the “worse case” scenario.


I tend to believe that the Estimated Low Price in the next 5 years is more likely to happen in the first 12-24 months; and I tend to believe that the Estimated High Price in the next 5 years is more likely to happen in the 3rd, 4th or 5th year.

One might take the % difference between each historical high and low price,
average these percentages, and then apply the average to your projected high
price to produce the projected low price.

There is absolutely no logic for selecting the average low price of the last five years. Stop and think. If EPS are rising for a growth stock, the low price for each year should be expected to gradually rise.


Personally, I look at 4B (a) and (c) for all companies under study and tend to lean to the lowest of the two but, before plugging that number into 4B1, I look at the 52 week low price - after all, it's "been there, done that".


My favorite possible low price is Line 4B(c)-Recent Severe Market Low. The condition, and it is a *big* one is that it be recent--in my view in the past 12-24 months.


I don't like the "x percentage lower than the present price" because there are too many lows based on real, hard numbers (previous P/Es, low prices, etc.) to grab for a percentage out of the blue.


I recommend that ICLers check the August 31 and October 8 lows of 1998 as they often turn out to be reasonable places to choose a Selected Estimate Low Price. [And now September 16, 2001, too!]


I emailed Investware asking what Toolkit chose for a Severe Market Low.
They said the program selects the lowest price of the last two years.


I lean toward using between 66% and 75% of the present price as a proxy for the severe market low, depending on the volatility of the company.


For me, the Estimated Low Price must be 10% (maybe 20% for a volatile stock) below its low price over the last 6-12 months.  I assume since the price has been there recently, it can go another 10-20% lower.

I should think that the application of the lowest P/E that we might
expect investors to pay, multiplied by the lowest earnings the company might be expected to produce handles it all. (Ellis Traub)


I use the PMG to look at the downs. I think it is analogous to picking my own SSG section 4Bc (recent severe low).  If the basic company has not changed, I think the price history can be useful in seeing how low the low price might go. 


Relative Value:


Relative Value is a warning device that will tell you if you’ve missed something in your quality assessment.


The definition is Current P/E (the current price divided by the sum of the earnings for the most recent four quarters) divided by the 5-year average P/E (or signature P/E).  We are looking for an RV of right around 100%.


Whatever the P/E of a stock is at the moment, it will tend to seek its normal or signature level. You are therefore looking for stocks where the RVs do not exceed 110%.  If the RV is on the high side, I have much less to worry about. For all practical purposes, it means that the investing public tends to agree with my evaluation.


On the other hand, an RV below 85-90% is probably your biggest concern because it suggests that people who are buying the stock today might know something negative about the company that you don’t know. 


There’s no question in my mind but that I must find out why the market currently would rather sell than buy the stock. It's either because of a FACT that I'm unaware of and should be; or it's because of a PERCEPTION that the market is moved by but has little basis in fact.


It is hard to judge RV when the stock has sold at such high P/Es for so that you can't justify keeping any of the high P/Es).  I would check the news of the company you are evaluating to see if there is any particular reason the stock is down that much. 


Lower estimates for future P/Es do not affect RV. (They will affect the upside/downside ratio). 


My strong recommendation:  If the RV is below 85%, move on. If the RV is above 110%, put off buying.


After you eliminate the Section 3 outliers to get your high and low P/Es, replace them. They will skew the RV and Projected RV.


Upside/Downside Ratio:


The Upside/Downside Ratio is a comparison of what you have to lose in the worst case versus what you have to gain if all goes as planned.


When the current price is above the sell range, the U/D ratio is 0% (it doesn't figure negatives).  This is a sign that you need to re-examine your judgments.


When the current price is below the bottom of the buy range, we get 99.9%.  Here, your Estimated Low Price is too high and must be lowered.


Be skeptical of double digit U/D Ratios, as it was a strong indicator of overly optimistic low price estimate.  This is the “unstable zone.”  Verify with other estimating methods.


You shouldn’t buy above your buy range.  Remember that stock prices can fluctuate as much as 50% per year.  Have patience.


Section 5: Total Return


Average Total Return (5C) is our selected growth pattern divided by 5 years.  This must be 20% in order to double our money in 5 years. 


The Compounded Rate of Return (also 5C) is the result of purchasing the stock at the current price and selling it at the high price in 5 years. This is a compounded figure which needs to be 15%.  These two are the “best case” scenario.

Projected Average Return (P.A.R) is a result of purchasing the stock at the current price

and selling it at the average price in 5 years. It’s also a compounded figure which needs to be 15%.


P.A.R. is calculated by multiplying the high earnings by the forecast average P/E rather than the forecast high P/E.


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