# A Simple Stock Valuation

by: David Merkel, CFA

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
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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:

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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 wrongâ€¦ but it can provide a jumping-off point for due diligence.