Download Intermediate_Concepts/Linking Current and Future Value

Part I
Linking Future Value with
Current Value
By Kevin Gillogly
HDIC Education Segment
March 14, 2005
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1
Reasons Most People
Fail in the Stock Market

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They Invest in
Companies They Don’t
Understand
They Don’t Know How
to Value a Stock
They Pay Too Much
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2
Linking Current Value
& Future Value
Current Value is _______?
 Future Value is based on ________?
 Knowing these two terms is a simple,
yet effective way, to protect yourself
from overpaying for a stock


Value of Classic’s Stock Wizard

Use red alerts to guide you
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3
Stock Valuation
Is a method of directly connecting
the stock price to the company’s
profits (EPS), and is expressed as
a ratio of price to EPS.
P/E Ratio = Stock Price / EPS
 Wall Street’s way of measuring the
value of the growth of the
company

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4
Price Follows Earnings
WAG
The price need not grow at the same rate
as the earnings. When EPS advances the
price will almost always advance.
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Section 3 for Walgreens
EPS growth has been around 17%.
Which of the high P/E’s are reasonable?
Which of the low P/E’s are reasonable?
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“Companies … with long records
of above average growth tend to
sell at higher P/Es, but their
highs are usually not
sustainable.”
-- Handbook, 130
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Stages of Growth
First things first. What type of growth is this
company? Use the SSG graph to help
determine (but use your judgment too) …
 A fast growth company?
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A stalwart growth company?
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> 10 & < 15%, looks like foothills of MTS
A slow growth company?
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> 20%, looks like peaks of a MT
< 7%, looks like topographical map of DE
A cyclical company?

Erratic growth, looks like the polygraph of a liar
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8
Stages of Growth
tion
Stabiliza
Life Cycle of
A Successful
Company
ro
wt
h
Exp
l
os
ive
G
No dividends
r t up
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Large dividends
(Payout ratio >40%)
Best
Investment
Opportunity
Small dividends
(Payout ratio <20%)
Speculation
Sta
De
cl
ine
th
ow
r
eG
r
atu
M
Break Even Point
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Where do sales come from?
Sales are the dollars that flow into the
company. It is what drives the growth of
the company. It can come from:

Selling more of a product or service
Making it better
 New uses for it
 Increasing demand for it


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Charging more for the product or service;
Increasing market share
Make it better/New uses/Increase demand
 Acquiring competitors


Acquire unrelated businesses
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Where do earnings
come from?
Earnings is what remains after expenses
and taxes. It can go to:



the owners (dividends)
pay off debt (loans, bonds)
be used to grow the company (equity)


Improve company operations
Acquire new companies
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11
“Buy the rights stocks at
the wrong price at the
wrong time and you’ll
suffer great losses.”
Peter Lynch, One Up On
Wall Street, Pg. 72.
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Applying Judgment

Be reasonably conservative

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But not everywhere in the SSG
And not all the time
Remember our goal is purchase
stocks not hoard cash


Be more aggressive on your future
EPS growth (Sec. 1-4)
Save your conservatism for your
future P/Es (Sec. 4A and 4B)

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Link 1-4 with 4A
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More Stock Valuation
Another method of stock valuation:


PE/G Ratio = PE Ratio / Future EPS
Growth Rate
Wall Street’s way of measuring the
value of the earnings of the company
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Using the PE/G Ratio

P/E ratio divided earnings growth
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ratio
ratio
ratio
ratio
of 1 = fairly valued;
of 2 = overvalued;
1.5 = upper limit of fairly valued
under 1 = on sale
WAG has a PEG ratio of 1.75


PE/G
PE/G
PE/G
PE/G
Current P/E of 29.6 divided by historic
earnings growth of 16.9
How is WAG valued?
What would be a fair future high P/E
value for WAG based on 16.9% EPS
growth?
Answer: 25.4
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Linking Current Value
& Future Value

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Forecasting a high P/E (4A) no higher
than 1.5 times (150%) of your future
EPS growth on the front of the SSG (1-4)
allows for the P/E to expand towards
200%.
Expanding P/Es is how to make money.
Conversely, a P/E that shrinks (or
contracts) is a sure fire way to lose
money.
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Using PE/G Ratio, Pt. 3
A high P/E of 46.2 / 15% future EPS growth = a
PE/G ratio 3.08. To make $107.72 in 5 years time
WAG would have to become severely overvalued.
Is this realistic?
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Linking Current Value
& Future Value


This allows us to test the
reasonableness of our estimated
EPS growth vs. our estimated PE
ratios
Sect. 4A ties high P/Es in Sect. 3
with our future earnings growth in
Sect. 1-4
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Projected P/E for WAG
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Setting Up Projected P/Es
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Projected P/E for WAG
This gives us another way to value P/Es.
To learn more: Classic Manual, pg. 98
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Another Way to Determine
Future Value

Add future P/Es along with future
EPS growth
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WAG has a projected P/E of 25.6
divided by future earnings growth of
15.0 for a PEG ratio of 1.71
How does this change WAG’s
valued?
Answer: No matter which metric we use WAG is
overvalued using the SSG. This is not surprising
for a well managed company with consistent EPS
growth.
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Conclusion
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
Look at the graph is it steady and growing?
Compare EPS growth with Divided Payout
Ratio (Sec. 3-G-7)
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Are dividends growing faster than EPS?
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Link future value (Sec. 1-4) with the current
value (Sec. 3-9)
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Reasonableness (of this link) is found in Sec. 4-A
(future high PE)
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That would be “pink” flag
Limit 4-A (future high PE) to no more than 150% of 1-4
(future EPS)
Test the reasonableness of your judgments
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Questions
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