chapter15 over-valuation & under- valuation - sydenham

8/13/2019 Chapter15 Over-Valuation & Under- Valuation - Sydenham

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Chapter 15

Establishing the Value Benchmark


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Tools for Judging Undervaluation or

Overvaluation

PBV-ROE Matrix

Growth-Duration Matrix

Expectations Risk Index

Quality at a Reasonable Price (VRE)

PEG: Growth at a Reasonable Price

ROE: Most important indicator of financial performance


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Overvalued High ROE

HIGH Low ROE High PBV

High PBV

Low ROE Undervalued

LOW Low PBV High ROE

Low PBV

LOW HIGHROE

PBV Ratio

PBV-ROE Matrix


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Growth-Duration Matrix

UndervaluedPromises of

growth

Dividend

cows Overvalued

High

Low

HighLow

Expected 5-YrEPS Growth

Duration (1/Dividend Yield)


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Expectations Risk Index (ERI)

Developed by Al Rappaport, the ERI reflects the risk in

realising the expectations embedded in the current market

price

Proportion of stock Ratio of expected future

price depending on growth to recent growthexpected future growth (Acceleration ratio)

ERI = X


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ERI Illustration

Omegas price per share =Rs.150

Omegas operating cash flow

(before growth investment)

Omegas cost of equity = 15 percent

Growth rate in after-tax cash operating

earnings over the past three years

Market expectation of the growth in after-taxcash operating earnings over the next three

years

= Rs.10 per shar

= 20 percent

= 50 percent


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ERI Illustration

Omegas base line value = = Rs.66.7

Proportion of the stock price coming

from investors expectations of future = = 0.56

growth opportunities

Acceleration ratio = = 1.25

ERI = 0.56 x 1.25 = 0.70

In general, the lower (higher) the ERI, the greater (smaller) the

chance of achieving expectations and the higher (lower) the expected

return for investors.

15066.7

150

Rs.10

0.15

1.50

1.20


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Quality at a Reasonable Price

Determining whether a stock is overvalued or undervalued is often

difficult. To deal with this issue, some value investors use a metriccalled the value of ROE or VRE for short.

The VRE is defined as the return on equity (ROE) percentage

divided by the PE(price-earning) ratio. For example, if a company

has an expected ROE of 18 percent and a PE ratio of 15, its VRE is

1.2 (18/15).

According to value investors who use VRE:

A stock is considered overvalued if the VRE is less than 1.

A stock is worthy of being considered for investment, if the VRE

is greater than 1. A stock represents a very attractive investment proposition if the

VRE > 2

A stock represents an extremely attractive investment

proposition if the VRE > 3


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What price should one pay for growth? To answer this difficult

question, Peter Lynch, the legendary mutual fund manager,

developed the so-called PE-to-growth ratio, or PEG ratio. The PEG

ratio is simply the PE ratio divided by the expected EPS growth rate

(in percent). For example, if a company has a PE ratio of 20 and its

EPS is expected to grow at 25 percent, its PEG ratio is 0.8 (20/25).


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Proponents of PEG ratio believe that:

A PEG of 1 or more suggests that the stock is fully valued.

A PEG of less than 1 implies that the stock is worthy of being

considered for investment.

A PEG of less than 0.5 means that the stock possibly is a very attractive

investment proposition.

A PEG of less than 0.33 suggests that the stock is an unusually

attractive investment proposition.Thus, the lower the PEG ratio, the greater the investment

attractiveness of the stock. Growth-at-a-reasonable price (GARP) investors

generally shun stocks with PEG ratios significantly greater than 1.


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Return on Equity

PAT Sales Assets

ROE = x x

Sales Assets Equity

Net Profit Asset Leverage

Margin Turnover


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Return on Equity

PBIT sales PBT PAT Assets

ROE = x x x x

Sales Assets PBIT PBT Net Worth

Thus, ROE = PBIT efficiency * asset turnover ratio *interest burden*

tax burden *leverage

chapter15 over-valuation & under- valuation - sydenham

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