Since I began posting at Seeking Alpha, I have had requests from my followers and others to explain my valuation techniques. I wrote an article using the Gordon Model in stock selection , but the requests have continued for a more thorough explanation. Therefore, I am writing that article now and will use PG as my example stock.
Valuation is the process of determining what something is worth. Although you could value a bond, a business, land, a house or other property (tangible or intangible), I will limit this article to valuation of a common stock. Absolute value is the present value of an asset's expected future cash flows. There are two forms of this, discounted cash flow of future earnings or Gordon Model for definite periods. I use a modified version of the Gordon Model for P/E valuation. There is the Dividend Discount Model which is similar to the Gordon Model . My version is simplified as the Tweed Factor: 1) fair P/E = yield + 5 year dividend growth rate. 2) Is the current yield 4% or greater?
During the current secular bear market, there is a relentless P/E compression over the 21 year bear which brings valuation down from the extreme overvaluation of 2000 to under valuation in 2020. This process has occurred many times in the history of the stock market with the last example being 1929-1949. Because of this compression, P/E ratio for capitalizing future earnings must be reduced to compensate. In addition with global central banks intervening in markets and determining which firms are too big to fail as well as keeping interest rates at historical lows through money printing, it is critical to take these facts into account when evaluating a particular stock. Which sector is the stock in? Will these governmental issues affect the stock valuation?
Stocks should be selected based on portfolio needs, such as total portfolio yield or sector allocation. Once selected, various financial and other tests should be made to assure that the prospective stock fits the needs of the buyer. Is the debt ratio too high? Is the prospective owner comfortable in owning the business (tobacco, military arms manufacturer, alcoholic beverages). What are the political repercussions of ownership (basic materials mining, oil, pipelines, power lines)?
For an example I will value Procter & Gamble (NYSE:PG). (Data from Yahoo Finance, and David Fish's CCC charts). Difu Wu wrote an article on Procter & Gamble on January 22, 2012 in which he determined a price range for PG. I will use his low P/E column from his Key 10-year data for Procter & Gamble to determine the (5-year) future P/E ratio. If one is simply looking to see if the stock is at a fair price today, the Tweed factor should suffice. However, if one wants to plan on a 5-year trade, then a future price is necessary.
Tweed Factor calculation: current yield = 3.2%*
5-year dividend growth rate = 11.2%
Fair P/E = 11.2 + 3.2 =14.4 compared to current P/E of 16.82
The stock is overpriced. *The yield is less than 4% minimum.
PG minimum P/E vs year
As can be seen from the table, the P/E ratio has declined from 24.2 in 2002 to 14.7 in 2011 for an average annual decline rate of .946 per year. Therefore, to project the current P/E 5 years into the future, the formula would be future P/E-5 =current P/E * (.946)^5 = (16.82)* .758 = 12.75.
Five year future earnings growth rate = 8.7% per year.
Five year future earnings per share = $3.93 * (1+.087)^5 = $5.96
Five year future price = P/E * earnings =12.75 * $5.96 = $76.04
Nominal gain = price gain + dividends
price gain = ($76.04/$66.23)^1/5 = 2.8% per year
dividends = current dividend + next 4 years dividends = $2.10 + $2.34 + $2.60 + $2.89 + $3.21
dividends = $13.13
Nominal gain = $76.04 + $13.13 = ($89.17/$66.23)^(1/5)= 6.12% per year.
For higher growth rate stocks (greater than 10% earnings per share growth rate) I use the larger of Tweed factor or the earnings per share growth rate for fair P/E. Many times, the dividend growth rate is higher than the earnings per share growth rate and sustainability must be taken into account for long term projections.
I have enjoyed ownership of PG for a long time and drip the dividends each year. This is another way to gain the good return, without making a large investment all at once. The advantages of dripping the stock provides a lower average cost than one could usually get by timing the market. It is critical that each investor does their own due diligence before making any investment.