Earning Years- the most simple and also the one that I use most often. It tells you exactly what the commonly used price to earnings or pe ratio tells you (number of years it will take for the cummulative earnings of a company to become equal to current price) but by taking growth into account. I called this parameter as Earning Years and its formula goes like this-
Earning Years (EY) = log ((pe * r/100) + 1)/log(1+(r/100))
where pe = current price to earnings ratio
r = expected future profit growth rate. Can be taken as equal to compounded profit growth rate of past 5 or even 10 years.
The best way to compute it is to use it at websites like screener.in where it can be used in many ways.
Lets take a simple example -
Bajaj Finance- with a current price of nearly 4000 it is trading at a p/e of 50. On pure p/e terms it is definitely overvalued. Its compounded profit growth rate of past 10 years is 60%.
Now using above forumla, its Earning Years (EY) is coming equal to 7.30. In other words its actual P/E is a mere 7.3 only, if we consider growth also into account and not 50.
In DCF calculations, future earnings (or free cash flows to be more exact) are discounted to present value which is then compared with current price. Determining future growth rate is the important key and can never be done accurately. It will also vary from business to business. I took a simple shortcut by taking growth rate (r, in above formula) as equal to compounded growth rate of past years. However, if one wants to be more conservative, one can define r by multiplying, say past 5 or 10 years growth rate with 0.6-0.5. Thus decreasing its value by 40-50% and thereby roughly incorporating oppurtunity cost and margin of safety into account. (Alternately one can also inflate the EY obtained earlier by 1.4 -1.5 times)
Personally I dont do any such tinkering and leave the formula as defined earlier. Still just for an example, lets recalculate EY for Bajaj Finance by decreasing its r by 50%. In previous calculation, value of r taken was 60. To be more conservative in our assesment, lets take r as 30. The EY now comes out to be 10.5 (approx). Thus, even after taking future risks and other such things into account the stock still appears to be reasonably valued than what the simple pe of 50 would let you believe.
I find companies undervalued if EY is lesser than 10 and to be reasonably valued if it is between 10-13. Definitely overvalued if it is above 13-16, depending upon company and sector. Obviously I cannot base my decision to buy or sell based on just one parameter as there are many things to consider like corporate governance, debt etc besides valuation. Also there are 2 other valaution parameters that I use in conjuction with this one that I will be sharing in my future posts.
One major advantage of using above method over DCF is I can define this parameter in websites like screener.in and then use it there. Like for instance I can search for companies by making screens like EY<=10 And Roce>=20, etc. Comparing different companies from same sector is also very easy.
P.S.- I was holding Bajaj Finance in my portfolio though sold my holding in it about two weeks ago as I needed cash. May reenter again sometime later.