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Chapter 15

Establishing the Value Benchmark

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

PBV-ROE Matrix

HIGH PBV Ratio LOW

Overvalued Low ROE High PBV Low ROE Low PBV

High ROE High PBV

Undervalued High ROE Low PBV HIGH ROE

LOW

Growth-Duration Matrix

High
Expected 5-Yr EPS Growth Low

Undervalued

Promises of growth

Dividend cows

Overvalued

Low

High

Duration (1/Dividend Yield)

Expectations Risk Index (ERI)


Developed by Al Rappaport, the ERI reflects the risk in

realising the expectations embedded in the current market


price

ERI =

Proportion of stock price depending on

Ratio of expected future growth to recent growth

expected future growth

(Acceleration ratio)

ERI Illustration
Omegas price per share Omegas operating cash flow
(before growth investment)

= Rs.150

= Rs.10 per share

Omegas cost of equity Growth rate in after-tax cash operating


earnings over the past three years

= 15 percent

= 20 percent

Market expectation of the growth in after-tax


cash operating earnings over the next three years

= 50 percent

ERI Illustration
Omegas base line value =

Rs.10 0.15

= Rs.66.7
150 66.7 150

Proportion of the stock price coming


from investors expectations of future = growth opportunities

= 0.56

Acceleration ratio =
ERI = 0.56 x 1.25 = 0.70

1.50 1.20

= 1.25

In general, the lower (higher) the ERI, the greater (smaller) the chance of achieving expectations and the higher (lower) the expected return for investors.

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 metric called 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

PEG: Growth at a Reasonable Price


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).

PEG: Growth at a Reasonable Price


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.

Return on Equity
PAT ROE = Sales x Assets Sales x Equity Assets

Net Profit Margin

Asset Turnover

Leverage

Return on Equity
PBIT
ROE = Sales x Assets

sales
x

PBT
x PBIT

PAT
x PBT

Assets
Net Worth

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