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Yesterday my brother and I were having a conversation about how to value a company. We concluded that a company should not be valued on price but on the correlation of the P/E multiple to the growth rate. So first we must understand and be able to figure out what the P/E multiple is. The P/E multiple can easily be expressed in the algebraic equation price of the stock (P) = the earnings per share (E) X the multiple. Another way to express that is P/E = M. That seems pretty easy and clear, but there is an important variable. The price of the stock is always changing. And this will chance the multiple accordingly.

This is a formula that is used by the hedge funds and they have all of the money and they make the rules. Therefore it is important for us to understand how the game is played and I can teach you.

For an example let’s use the stock Cisco (CSCO). The price of the stock Friday was $15.90 and the earnings per share were $1.27 this quarter. If we divide the price of the share (P) by the earnings per share (E), we come up with a multiple of 12.50.

However, it’s not quite that easy. To really understand valuation we must also know what the growth rate is. The projected growth rate for Cisco last quarter was 6%. A rule of thumb that most professionals and I like to use is to take the growth rate and double it and compare it to the multiple. A stock that has a multiple equal to twice the growth rate is considered to be fully valued. If we use Cisco as an example we have already determined that the P/E multiple is 12.50 and the projected growth rate is to be 6%. So we now double the growth rate and come up with 12 and compare it to the multiple which is 12.5 and we can see that Cisco is a tad overvalued or expensive.

It is important to bear in mind that a company’s share price does not tell us one thing about whether a stock is expensive or not.

The P/E multiple, when related to the growth rate, will specifically tell how much investors should be willing to pay per dollar of earnings. By looking at the P/E multiple in relation to growth, people are able to tell whether a stock is overvalued or undervalued or whether it is expensive or not.

The multiple is the main way to determine value, but growth will tell you what most people will be willing to pay for a stock. This is why it is so important for investors to examine how much bigger the earnings will be next year and the year after, etc. Companies with faster growth tend to get rewarded with higher multiples. The more rapidly a business grows, the bigger its future earnings will be.

Friday, as I played with this theory, I put in different stocks to determine whether they were expensive or not.

We have already done the math on Cisco and determined that it is an expensive or slightly overvalued stock. To review, we have determined the P/E multiple is 12.5 and the growth rate is 6%. I reminded you all that professional investors will be willing to pay up to a P/E multiple that is twice the growth rate. So if we double the growth rate we come up with 12 and the P/E (Friday) was 12.50. This leads me to conclude that Cisco is a very expensive stock.

Now let’s look at Apple (AAPL). If we take the price per share (P), which is $357.20, and divide by the earnings per share (E), which is $20.98, we come up with a P/E multiple of 17.02. The growth rate of Apple is 52%. So if we double the growth rate we come up with 104. If we use our rule of thumb we see that we would be willing to pay a P/E multiple of 102 for Apple to be fully valued. Well, the P/E multiple is 17.02, which makes Apple a very cheap stock. So we have determined that Cisco, which sells for $15.90, is an expensive stock and have determined that Apple, which sells for $357.20, is a very inexpensive stock.

The price of the stock does not tell us anything about how expensive or cheap a stock is.

Determining these variables is less a science and more of an art. When you buy a stock you are buying a small piece of the company’s projected future earnings stream. That is because P/E multiples and multiples and growth are not static numbers. Multiple expansion is when they pay more, and multiple contraction is when they pay less. Earnings aren't static. When you buy a stock, you're either making a bet that the E or the M part of the price equation is heading higher.

When it comes to earnings, people often talk about the bottom line, profits or net income, which are terms used interchangeably. It's called the bottom line because the number is the bottom figure on the company's income statement. To tell if earnings will continue to rise, I think it is essential to listen to the company's conference call regarding its quarterly earnings results. The company will talk about its top line, which is revenue or sales. Strong revenue growth tells you there is strong demand for the company's product, which is ultimately key to a company's ability to grow earnings long term. Another important thing to consider is the gross margin. It is what percentage of every dollar of sales becomes profit and an indicator of how much money a company can make. To compute gross margins, consider the competition, cost of production and cost of doing business. Businesses with cut-throat competition will have terrible margins, but companies with great market share will have huge margins. Every industry is different.

So in conclusion, you need to know the vocabulary before you can evaluate a stock. When you’re comparing, you want to look at the top line, the bottom line and the gross margins but most of all you want to use the hedge funds rule of thumb. The P/E multiple that is equal to double the growth rate is considered a fully valued stock so we want to look for stocks that are not fully valued and still have room for price expansion.

Disclosure: I am long CSCO, AAPL.

Source: On Apple and Cisco Multiples, Or How to Truly Value Stocks