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Chapter 15
Establishing the Value Benchmark
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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
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Overvalued High ROE
HIGH Low ROE High PBV
High PBV
Low ROE Undervalued
LOW Low PBV High ROE
Low PBV
LOW HIGHROE
PBV Ratio
PBV-ROE Matrix
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Growth-Duration Matrix
UndervaluedPromises of
growth
Dividend
cows Overvalued
High
Low
HighLow
Expected 5-YrEPS Growth
Duration (1/Dividend Yield)
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Expectations Risk Index (ERI)
Developed by Al Rappaport, the ERI reflects the risk in
realising the expectations embedded in the current market
price
Proportion of stock Ratio of expected future
price depending on growth to recent growthexpected future growth (Acceleration ratio)
ERI = X
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ERI Illustration
Omegas price per share =Rs.150
Omegas operating cash flow
(before growth investment)
Omegas cost of equity = 15 percent
Growth rate in after-tax cash operating
earnings over the past three years
Market expectation of the growth in after-taxcash operating earnings over the next three
years
= Rs.10 per shar
= 20 percent
= 50 percent
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ERI Illustration
Omegas base line value = = Rs.66.7
Proportion of the stock price coming
from investors expectations of future = = 0.56
growth opportunities
Acceleration ratio = = 1.25
ERI = 0.56 x 1.25 = 0.70
In general, the lower (higher) the ERI, the greater (smaller) the
chance of achieving expectations and the higher (lower) the expected
return for investors.
15066.7
150
Rs.10
0.15
1.50
1.20
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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 metriccalled 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
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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).
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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.
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Return on Equity
PAT Sales Assets
ROE = x x
Sales Assets Equity
Net Profit Asset Leverage
Margin Turnover
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Return on Equity
PBIT sales PBT PAT Assets
ROE = x x x x
Sales Assets PBIT PBT Net Worth
Thus, ROE = PBIT efficiency * asset turnover ratio *interest burden*
tax burden *leverage