As a value investor, your main objective is to determine the intrinsic value of a stock you're considering buying -- that is to say, what a stock is actually worth as opposed to what the market is simply valuing it at. From there, you're hoping the stock will be trading at a significant discount to its intrinsic value, thus encouraging a buy decision (that is, of course, if the rest of your fundamental analysis is confirmed as well). As value investors know, however, calculating intrinsic value is not cut and dried, and there exist countless methods of doing it -- from complex discounted cash flow (DCF) models to a simple comparison of P/E ratios between the company of interest and its peers.
One useful approach comes in the form of an equation created by legendary investor, Warren Buffett mentor, and finance professor Ben Graham. This equation for valuation finds a middle ground between more complex DCF calculations and the more simple methods using P/E or P/B ratios comparatively. It is not intended to be a comprehensive measure of value, but it works well in conjunction with other valuation methods and fundamental analysis to provide an estimate of intrinsic value, based largely off of a company's growth rate (which is one factor that makes up intrinsic value).
Here's the formula:
IV = EPS * (8.5 + 2g)
IV = Intrinsic Value
EPS = trailing 12 months EPS
8.5 = The P/E ratio of a no-growth company
G = The long-term growth rate of a company (i.e., 7%)
Basically, the right side of the equation after the multiplication sign is Ben Graham's method of calculating the fairly valued P/E ratio of a company. When you multiply that by the EPS, you get the intrinsic value. As a value investor, you're hoping the P/E ratio calculated by the right side of the equation is higher than the current P/E ratio, thus creating an intrinsic value higher than the current value.
The problem with Graham's equation is it often produces irrationally high valuations. Ideally, the P/E ratio of a company should reflect a company's growth prospects. A company with a very high growth rate for the long term (such as 30%) should trade at a high multiple to its current earnings, whereas a company with low growth prospects should trade at a low multiple to its earnings. Graham assumes a company with no growth has a P/E ratio of 8.5, so what he does is add that to 2x the growth rate (a very generous and hard to justify multipier) to produce a P/E ratio that reflects a fair value.
For example, Suncor Energy (NYSE:SU) has a 12 month EPS of $3.21 (This is using the operating EPS instead of GAAP EPS for the Q2 2014 earnings) and an analyst long-term growth rate consensus of 7%. Let's plug this into Graham's formula:
IV = 3.21 X (8.5+2(7))
IV = 3.21 X 22.5
IV = $72.22
Suncor is currently trading at $43.00 (CDN), and most valuation work would suggest that a $72.22 (CDN) IV for Suncor's growth rate, current EPS, and fundamentals is probably high (most estimates are in the $45-$50 range).
How do we correct for this? We have seen Ben Graham's method for determining a fair P/E ratio (8.5 + 2g), but investor Peter Lynch adopts a different approach. He says that the P/E ratio of any company that's fairly priced will equal its growth rate. In other words, P/E simply equals G, instead of 8.5 + 2g. Intrinsic value would simply then equal the EPS multiplied by the growth rate. This approach, however, suffers from the opposite problem: It will yield far too low intrinsic values. For Suncor once again, we would use 3.21 (the EPS) x 7 (the P/E ratio or growth rate) to get an intrinsic value of $22.47. This is absurdly low.
What is the solution? I propose a compromise between these two investors, and it is an approach to valuation that has worked well for me. The answer is to acknowledge Lynch's basic insight that P/E should be a reflection of growth rate, but not to the extent where it is a perfect reflection. This is where Ben Graham's notion of an 8.5 P/E for a zero-growth company becomes useful.
As Ben Graham says, the P/E ratio for a company with no growth should equal 8.5 (refer to the Ben Graham formula above). By using 8.5 as a base for a zero-growth company instead of zero as Lynch would assume, we have an automatic premium added to the growth rate -- a premium that prevents the kind of unrealistically low results demonstrated earlier. Companies with low single-digit growth rates seldom have low single-digit P/E ratios, so a premium is clearly to match the markets realistically.
This allows the P/E ratio to be largely a function of growth, but added to a base number that creates results that are sensible in the current marketplace and approximate well the results determined by more refined valuation methods. I believe this is a more reasonable approach to valuation than the original Graham formula, and provides an excellent starting point for a more thorough valuation. Remember, our goal here is to find a fair multiple for our earnings. This approach allows us to roughly relate growth rate to P/E, and to determine what a fair P/E ratio for a particular growth rate is. By using this in combination with other fundamentals such as ROE, earnings growth, and a companies competitive position, we can get a good sense of a company's intrinsic value.
Here is the revised Ben Graham Formula:
IV = EPS X (8.5 +g)
For Suncor, this would yield an IV of $49.75 (3.21 X (8.5 + 7). This is a far more reasonable, conservative figure, and in line with most analyst valuations done using more complex methodologies.
Disclosure: The author is long SU. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
Disclaimer: This formula is not intended to replace a comprehensive analysis of a stock, and a buy decision should not be made solely on its result.