Simple Stock Valuation

I appreciate Eddy Elfenbein.  He comes up with ideas that make me say, “Huh. Interesting.  Let’s test that.”  His recent article, World’s Simplest Stock Valuation Measure, put forth the idea that:

Growth Rate/2 + 8 = PE Ratio

Cool, reminds me of my 1993 formula for value investing:

Price per share < Tangible Book per share + 5 * EPS

Eddy’s idea is that you can buy a company that isn’t growing or shrinking earnings at a PE of 8, or alternatively, a E/P (earnings yield) of 12.5%.  In a weird environment like this, it means an earnings yield that is more than 9% over the long bond is a good purchase.  I like that idea, it offers a good reward for taking risk.

But as the growth rate rises, you can expand the PE multiple by half of the anticipated growth rate.  So, a company anticipated to grow at a 10% rate would warrant a PE multiple of 13, a 20% rate 18, etc.  I like his formula, because it is conservative.  It seeks growth at a reasonable price.  It will not overpay for high growth rates.

But now let’s test this statistically to see what validity it presently has.  I ran a regression on Current year expected PEs versus expected 3-5 year growth rates.  I excluded all companies with fewer than two analysts putting forth growth estimates.  Here were the results:

SUMMARY  OUTPUT

Regression Statistics

Multiple R

0.15

R Square

0.0224

Adjusted R Square

0.0218

Standard Error

39.70

Observations

1,589

ANOVA

 

Df

SS

MS

F

Significance F

Regression

1

57,333

57,332.91

36.38

0.000000002

Residual

1,587

2,500,838

1,575.83

Total

1,588

2,558,170

   

 

Standard Error

t Stat

P-value

Lower 95%

Upper 95%

Eddy

T-test

Intercept

11.87

1.88

6.33

0.0000000003

8.19

15.55

8.00

2.06

eps_eg5

0.69

0.11

6.03

0.0000000020

0.47

0.91

0.50

1.66

 

Significant results statistically, but what a low R-squared.  Just shows us all how complex the market really is.  Look at this graph to see it as it is:

There really doesn’t seem to be much of a relationship.  But Eddy’s formula is conservative versus the estimates.  His formula invests in no-growth  companies  at an earnings yield of 12.5%, the market does so at an earnings yield of 8.4%.  His formula increases the PE multiple at a 50% rate as earnings increases, but the market does so at a 69% rate.

Good for Eddy, and any that follow him.  His method builds in a margin of safety, which is a key to all good investing.

Before I close I would like to offer the 20 most mispriced companies, both positively and negatively.  Just be aware that the markets are complex, and this valuation method is simple, and most likely wrong… but it can provide a jumping-off point for due diligence.

Potential Buys

companytickereps_eg5PE
Seagate Technology PLCSTX

37.94

4.3

US Airways Group, Inc.LCC

38.5

4.9

China Xiniya Fashion Ltd (ADR)XNY

12

2.6

Exide TechnologiesXIDE

15

3.4

HollyFrontier CorpHFC

31.19

5.3

First Solar, Inc.FSLR

20

4.2

Xerium Technologies, Inc.XRM

20

4.3

YPF SA  (ADR)YPF

13.69

3.9

Newmont Mining CorporationNEM

54.68

9.6

Western Digital Corp.WDC

20.84

5.1

Gulfport Energy CorporationGPOR

48

9.1

Delta Air Lines, Inc.DAL

17.25

4.9

KKR & Co. L.P.KKR

22.43

5.7

Dana Holding CorporationDAN

31.56

7.1

Perfect World Co., Ltd. (ADR)PWRD

9.78

4

Marathon Petroleum CorpMPC

25.16

6.3

Stoneridge, Inc.SRI

35.2

7.8

GT Advanced Technologies IncGTAT

11

4.2

Telecom Argentina S.A. (ADR)TEO

11.3

4.3

SUPERVALU INC.SVU

11.1

4.3

 

Potential Sells

CompanyTicker

eps_eg5

PE

Rubicon Technology, Inc.RBCN

15

125.6

NetSuite Inc.N

34.79

204.1

Amazon.com, Inc.AMZN

30.02

190.6

Clear Channel Outdoor HoldingsCCO

24.04

175.5

Servicesource International InSREV

27

192.1

Wright Medical Group, Inc.WMGI

9.43

117.1

Lamar Advertising CoLAMR

4

96.8

Cogent Communications Group, ICCOI

17

170.5

Shutterfly, Inc.SFLY

18.75

182.6

Lattice SemiconductorLSCC

11.5

165.3

Conceptus, Inc.CPTS

17.5

201.6

CepheidCPHD

20

225

Black Diamond IncBDE

2.33

146.9

Quidel CorporationQDEL

17.5

421.5

WebMD Health Corp.WBMD

15

485.1

SL Green Realty CorpSLG

-3.09

230.2

Diana Shipping Inc.DSX

-16.62

11.4

Netflix, Inc.NFLX

16.96

803.8

Citi Trends, Inc.CTRN

10.67

942.7

Weatherford International LtdWFT

-30.72

11.4

That’s all for now.