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Summary

  • The widely-used P/E ratio is a limited stock valuation tool.
  • The best stock valuation tool is the earnings yield, which has more functionality than the tired price-to-earnings ratio.
  • The PEG ratio is an attempt to value stocks while accounting for short-term growth, however it too has a limited use.
  • The Earnings Yield Growth Root is a new metric that offers a solution to better grade company valuations while accounting for both earnings and growth.

"Is this the land that has the fountain of youth?" - Juan Ponce de Leon

While Ponce de Leon was searching for the fountain of youth, he inadvertently found Florida, now America's great retirement state also known as "the sunshine state."

For investors, the eternal quest is to find a measure of valuation that, in short, will find inefficient pricing that will lead to greater returns. Rather than reverse aging and live forever, investors are looking to increase wealth and live richer.

Current Valuation Model Makes No Sense

The most common form of evaluation of the value of a company is the standard P/E ratio. In a recent article on Altria Group, Inc. (NYSE:MO), the author wrote the following in his conclusion:

...shares of Altria are trading down about 3%. This selloff seems unreasonable given the results and strong 2014 guidance. At current prices, Altria now trades at a forward PE of under 14x.

The conclusion then followed with a shout-out regarding a strong history of dividend growth.

The argument here covers the four points:

  • A 3% decline is a sell-off
  • Sell-off is unreasonable due to strong 2014 guidance
  • A forward P/E ratio under 14x is a good deal
  • Buy MO because of unreasonable sell-off, past dividend growth and low valuation

Rather than support or disagree with this logic, one must ask how qualified is "under 14x forward earnings."

The number itself, 14x, is related to nothing in itself. You cannot measure it against anything other than historical context within the company and the relative pricing of other securities.

The P/E ratio bears no witness to the time value of money, however the earnings yield, which is found by dividing annual earnings by the current stock price, does. If a stock is trading at 14x earnings for example, the earnings yield (E/P) would be 7.14%.

Finding A Better System: The Earnings Yield

The earnings yield accounts for the cost of money, whereas the P/E ratio does not. If an investor can invest in a risk-free treasury or money market fund at 8% for example, then he or she would be more inclined not to invest with MO over the year (with an earnings yield of 7.14%).

If the risk-free rate of return is 4% however, then MO would make sense as a prudent investment (assuming MO is the only stock and no other variables exist).

In this sense, the earnings yield accounts for the risk premium in stocks versus bonds, which equals the time value of money.

For example, if 10-year U.S. treasuries yield 4%, Baa 10-year investment-grade bonds trade yield 5.5% and MO trades at an earnings yield of 7.14%, then the risk premium of MO is 164 basis points over Baa bonds, which also has a risk premium of 150 basis points over the 10-year treasury (100 basis points = 1%).

Risk Premium Chart, Theoretical Using Example Above (Basis Points)

U.S. TreasuriesBaa CorporatesMO
U.S. Treasuries-150314
Baa Corporates -164
MO -

As the P/E ratio has no way to account for the time value of money, the metric is clearly limited in value versus the earnings yield.

The Price-To-Earnings Growth Ratio (PEG Ratio)

In addition to accounting for the cost of money, investors have to account for the short-term growth rate of MO, which introduces us to the solution that the PEG ratio was created for.

In PEG terms, the valuation metric is very simple. Above 1 is overvalued, 1 is fair value, and if a stock is below 1, then it is undervalued. To determine the PEG ratio, the investor must take the P/E ratio and divide it by the short-term (usually 3 o5 years) corporate growth rate.

With MO as an example, if the stock is trading at 14x earnings with a 7% growth rate, the PEG ratio is 2. This states Altria is overvalued and should drop 50% to reach a 1, or fair valuation ranking.

The PEG ratio cannot be used for companies with low or negative growth rates however. If a stock has a 5% growth rate, according to the PEG ratio, it should trade at 5x earnings at fair value, or a stock with a 2% growth rate would trade at 2x earnings at fair value, etc...

If company X had a 2% earnings growth rate and a PEG ratio of 1, there would be 50% profit in one year. This would not last long, as investors would quickly bid up the price of company X, especially if a strong dividend was in place (which would make sense if the growth rate was so slow).

Summarizing The P/E, Earnings Yield & PEG Ratio

To review, the P/E ratio is useful and very easy to produce. It is valuable to compare historical company valuations as well as peer-to-peer analysis. Each increment of one on the P/E ratio is the same, one more times earnings.

The P/E does not account for the time value of money, which is related to the risk premium versus less risky assets. As such, the earnings yield is a much more useful valuation tool.

The PEG ratio attempts to account for the short-term growth of a corporation, however it is like a light switch: either a company is over-valued or under-valued.

A New Method of Valuation: The Earnings Yield Growth Root

Rather than use the PEG ratio, the newly-discovered Earnings Yield Growth [EYG] Root offers an exponential analysis to measuring stocks that can be used to determine relative stock valuation in terms of short-term projected growth rates.

The solution is as follows:

  • (Ye)(G3) = X2

With the variables defined as:

Ye = Earnings Yield percentage

G3 = 3-Year EPS Growth Rate

X2 = EYG

X = EYG Root

The EYG root is based on the earnings yield, which accounts for the time value of money. Since earnings yield can be used for historical and relative stock valuation and can compare corporate profitability to bond yields, it theoretically should replace the more limited P/E ratio.

The second component of the EYG is the 3-year EPS growth rate, which is used instead of the 5-year, as it is easier to predict and update. The EYG root stands for "earnings yield growth root," inferring a relationship between the earnings yield and EPS growth rate.

Testing The EYG Root

The next chart showcases Corporation X with $1 expected in 2014 earnings and a 7% short-term growth rate. The price is $10, which has a PEG ratio of 1 and a EYG root of 10.

To look at the valuations of Corporation X should the stock move up or down at dollar increments, the investor can note the differences in all four valuation metrics and how they relate.

(click to enlarge)

Now Corporation X is valued at $20 per share with $1 earnings, however the growth rate variable is changed. Note that when the PEG ratio is 1, the EYG root is once again 10.

(click to enlarge)

The relationship between the PEG ratio and the EYG root is exponential and will always follow the following chart (valid with positive short-term growth expectations only).

To look closer at relevant numbers, since low-growth corporations are not easy to measure, here is a closer view.

Zoom in a little further, and you have the relative rankings that are useful to the investor.

(click to enlarge)

As visually noted by the charts above, the EYG root has a defined inverse exponential relationship to the PEG ratio. Also, the EYG root gives a grade that could used in a similar fashion to A-F grading system used in the educational system.

(click to enlarge)

Application Of The EYG Root

When looking at the PEG ratio, the further the number is below 1, the more the company is undervalued. In testing the EYG root however, due to the inverse relationship with the PEG ratio, in terms of expected profitability and growth, the more undervalued the company is, the higher the EYG root will be.

In the chart below, three companies will be evaluated in terms of P/E versus the earnings yield [EY] as well as the PEG ratio versus EYG root.

(click to enlarge)

As noted above, ConocoPhillips (NYSE:COP) is the least expensive stock in terms of P/E or EY (earnings yield). When accounting for growth however, Apple Inc. (NASDAQ:AAPL) is shown to hold the lowest valuation.

The PEG ratio of AAPL is 1.13, with a 3-year projected growth rate of 11%, while the EYG root is 9.4.

Rather than use the PEG ratio, which aims to compare this group in terms of a set of numbers between 1.13 and 1.74 that all express overvaluation, the EYG root uses a number set between 7.6 and 9.4.

When ranking the companies in terms of the A-F grading system, Conoco-Phillips (COP) is graded a low B, Apple (AAPL) is an A and Wal-Mart Stores, Inc. (NYSE:WMT), which offers the least in terms of valuation, is ranked a C.

Conclusion

Investors who currently use the P/E ratio should note that the earnings yield is a better valuation tool, as it can be used to compare the relative valuation of stocks as well as the risk premium of a security versus the stock market and bonds.

In accounting for growth, the PEG ratio is a tried-and-true method, however the EYG root has a true grading efficiency that the PEG does not.

To return to our example of a theoretical Altria trading at 14x earnings with a 7% short-term growth rate, the PEG ratio of 2 equates to an EYG root of 7.1, or a C- grade.

According to S&P Capital IQ, as of March 7, 2014, MO was expected to earn $2.57 in 2014 with a 3-year expected growth rate of 7%. As such, the current PEG ratio would be 2.05 with an EYG root of 7.0.

Source: Introducing The Earnings Yield Growth Root