7th letter to friends of Brunei [Stock Valuation (part 4)]

The most common way to value a stock is through Price-Earning (P/E) ratio. Using the current P/E ratio x Estimated earning for the next 1 year will give an estimated intrinsic value of a stock. Let me first explain P/E ratio.

There are 2 ways of calculating P/E of a stock.

1. The accounting method

This method uses the current price of the stock divide by the immediate past year earning per stock. For example, if the company has the following performance:

Sales $2.0M

Expense -$1.5M

Earnings $0.5M

Assuming company has 1M stocks outstanding.

The Earning Per Stock (EPS) is $0.5M/1M = $0.50 per stock

If the Price Per Stock is $10, then the P/E = $10 / $0.5 = 20

This method is simple, but one has to take note that this method uses historical data (i.e. past earnings) which sometime might not give an accurate indication in the future. Especially if the company's business is highly volatile.

2. The Dividend Discounted Method (DDM)

The other method is to derive P/E from the DDM formula which we learn earlier.

Po = D1 / [k -g]

Let's divide E1 by both side,

Po/E1 = (D1/E1) /[k-g], where (D1 / E1) is actually the Dividend Payout Ratio (DPR)

Therefore, P/E = DPR / (k-g)

(This method is forward looking as compared to the accounting method.)

The intrinsic value of stock (Po) = E1 x DPR /(k-g)

Example: The Lego Corporation currently has earnings that are $4 per stock. In recent years earning have been growing at a rate of 7.5%. If the Lego Corporation has a retention rate of 40% & a required rate of return of 14%, what is the current intrinsic value of the stock?

Estimated earning for the next 1 year (E1) = $4 (1+0.075) = $4.3

DPR = (1 - Retention Rate) = (1 - 0.4) = 0.6

k - g = 0.14 - 0.075 = 0.065

Therefore, intrinsic value of stock (Po) = E1 x DPR /(k-g) = $4.3 x (0.6 / 0.065) = $39.69

Exercise: The Miller Corporation has current earning per stock of $6. Assume a dividend payout ratio of 55%. Earnings grow at a rate of 8.5%. If Miller's required rate of return is 15%, what is its current(intrinsic) value?

a. $51.33

b. $55.08

c. $57.02

d. $52.05

You can do this exercise, you would have understood the concept.