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# Chapter 15

## 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

## 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

## Expectations Risk Index (ERI)

Developed by Al Rappaport, the ERI reflects the risk in

price

ERI =

## expected future growth

(Acceleration ratio)

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

= Rs.150

## 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

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