ValuePickr Forum

My valuation technique

Hello, Greetings and Happy Diwali to members of this forum. I have been reading this forum since last year, though I have joined only recently and this is my first post.

I started to invest in Stock market about 1.5 years ago so I am far from an expert. However as a teacher of mathematics, the valuation techniques commonly used like DCF/DDM etc. clicked instantly with me. Though I never used them myself, because initially I believed I need more experience to use them reliably, but over time I have devised my own technique to evaluate companies which I thought of sharing them here. Hopefully it will be useful to many other members also. I would also request experienced members to share their feedback for further improvement.

There are already many valuation ratios like price to earning, price to book, ebit/EV etc. that are simple to understand but very much limited while techniques like DCF or DDM are somewhat complicated. So I developed 3 simple parameters that tries to incoporate the best of both.

These parameters are explained below in the following next posts.

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  1. 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.

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A few questions:

  1. Your post talks about DCF, but there’s no consideration of cashflows in your valuation method. Why is this the case? Which brings me to the next question:
  2. The valuation method only considers Growth as the major parameter (P/E is an input, not an assumption). What about the other drivers of value like Margins, Reinvestment, Depreciation, Risk and Competitive Advantage Period?
  3. If the logic is that all of these are captured by Profit Growth itself, how is this method any different from say, the PEG ratio?
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@dineshssairam

The intention was to improve upon the pe ratio, since it deals with earnings and not cash flows so I based my method around that. Another important thing was, I wanted to use such parameters at websites like screener, so I tried keeping it simple by building such parameters with not many variables.

As far as Peg ratio is concerned, that one never made any sense to me, I meant the logic behind it.

A pe ratio of 30 for a company tells you that it will take 30 years for the earnings of the company (assuming constant) to catch up with the current price. However, if the same company is growing at 30% then it will take only 8.7 years for its earning to catch up with the current price. This is what my simple ratio described in my previous post tells you, the actual pe you can say because it takes growth into account. The peg ratio for the same company would be 1. Ok, but what exactly that is supposed to mean ? I cannot understand the logic behind it. Understanding pe is far simple.

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Have you had a chance to back test this valuation technique? I mean have you analysed the returns of under valued stocks over a period of time?

@Ferrari1976

No I haven’t backtested it with any proper method and collected data, but based on a general observation, yes many undervalued stocks do make good upmoves. However, the price movement may not necessarily be because of just undervaluation only. Also, some stocks do appear overvalued based on the simple pe ratio, but actually maybe undervalued after taking growth into consideration. For example bajaj finance, and even dmart till few months ago, not now, (when its price was near 1300 and still had high pe), but based on above parameter, I observed market more or less values them rightly. But like I said, the period of time where I observed is not high enough to reach any definite conclusion.

Besides, the important thing is valuation is an important criteria in stock selection, but not the only criteria, and where the above parameter can be helpful in determining that since it is just an extended form of p/e.

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Hi Abhishek,
I find this logic helpful. It makes a lot of sense.
Have you made the ration in screener under => https://www.screener.in/ratios/
Could you share the code for that. I do not see LOG function available there.

Thanks. Saurabh

@saurabhshares Yes, I developed it at screener. There might be some syntax error because of which you are unable to access log function. Here is the snapshot

In the formula field, just paste this

log(1+ ((Price to Earning * Profit growth 10Years )/100))/log(1+ (Profit growth 10Years /100))

Note- compounded profit growth of past 10 years is not available for all companies, so screener will show blank for such cases.

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The Earnings Years (EY) is a good improvement on PE ratio. PEG ratio doesn’t quite serve the purpose. A company projected to grow at 30% for next 10 years and selling at 30 PE will give superior returns to a company growing at 20% and 20 PE, even if their terminal PE is same.

However EY becomes a speculative ratio. Its value will depend upon the individuals’ speculation about the future growth rate. Some businesses are highly predictable, you can be sure about their capability to sustain last ten years growth rate. For them EY can be computed as you have done. But others can be easily disrupted, and using EY at the peak of their business cycle can give false impressions.

One suggestion: You may want to replace r (expected growth rate) with r’ (expected real growth rate) by subtracting the discount rate, since the cashflow from any future year must be discounted before adding into present cash flow. This may help show how some of the low PE companies with negative real growth rate are actually overvalued.

Also EY alone does not determines whether the business is undervalued or not. It must be compared to growth runway available to company, by determining its opportunity potential and its ability to capture it. To take an example, a company with EY 10 but whose market will get saturated in 20 years at the projected growth rate may be costly than one at 15 EY but with the ability to keep growing for 30 years.

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What if rate of growth i.e r =0 ? This can happen in cases like rental income generating companies. EY will be 0 ?

It will be equal to current pe then, however screener may show it as blank in that case.

Sorry for the delay in updating this thread, some other parameters I use are explained below-

  1. Dividend Years (DY)-

Just like the previously described “Earning Years” which improved upon the commonly used pe ratio by taking growth into account, this parameter does a similar job by building upon the commonly used dividend yield but by taking growth into account. It tells how many years it will take to recover your buying price from cummulative dividends. Its formula goes like this-

DY = log (1+ (pe*r/d)) / log (1+(r/100))

Here pe= pe ratio of the company, r= expected profit growth rate, can be taken as avg. growth rate of past 10 years to remove cyclicality, d= dividend payout ratio of the company, again can be taken as average of past many years.

If you like thinking in terms of dividend yield, the above parameter can give a better picture of that as it also considers growth. You can calculate it as 100/DY.

This parameter is expected to work well only for consistent dividend paying companies that are growing at a stable rate. This is because it assumes dividend payout ratio to be constant and dividend growth thus to be same as profit growth. For inconsistent companies like Heg, which perform in bursts, DY will paint a very wrong picture.

My idea is to capture solid bluechip companies that pay consistent dividends but at reasonable valuations using this parameter. For example, take HDFC bank. If one looks at its dividend yield, its a paltry 0.58%. However, combining its growth rate with it using above formula, it comes out much better around 6%. That doesnt mean I will get 6% dividends starting next year. It is meant for long term investing, infact dividends themselves are important for long term buy and hold kind of investing. Personally I look for bluechip companies for which DY is lesser than or equal to 12-10 (or actual dividend yield is more than 8.5%-10%)

Disc.- Not invested in HDFC.