How to Value Stocks Like a Pro Using the Absolute PE Model

Introducing Mr Katsenelson and the Absolute PE Model

Back in 2011, I got around to reading and applying Vitaliy Katsenelson’s book Active Value Investing which I also list in my best investment books for value investors.

In it, he lays out a simply framework as well as a valuation method which he calls the absolute PE model. I use this model in my stock analyzer as an alternative to simply relying on relative valuations.

If you haven’t read the book, check out my review of Active Value Investing because it’s a very informative and resourceful book.

Plus, if you want to see how a pro goes about thinking about the markets and valuing stocks, it certainly is worth the read.

There is a lot of information to process to understand how this stock valuation method works and how it all comes together. At 2,500 words, there is a lot of reading here.

Keep in mind that all the information is directly from the book. I’m just adding my interpretation and application here.

This model derives the intrinsic value of a stock based on the following five conditions.

1. Earnings growth rate
2. Dividend yield
4. Financial risk
5. and earnings visibility

Like all valuation models, there is subjectivity involved.

In this case, you are required to grasp an understanding of the business and then quantity the level of risk involved.

You have to decide whether the business risk is low or high and assign a premium value to it or give it a discount.

It’s confusing at the moment, right? But you’ll get it by the end of this article.

Core Principles of the Absolute P/E Model to Understand First

Since this model is based on the workings of the 5 conditions mentioned above, it’s important to understand the big picture for each condition.

Instead of just trying to get the formula and start working on it, take a step back, look at the big picture and you’ll find it really easy to use this absolute valuation model.

Principal #1: Assigning a No Growth PE as a Start

Part of the reason why I created the no growth PE screen backtest was because of this valuation method.

I needed to know whether my conservative nature of using a PE of 7 for no growth was factually correct. My results show that a PE range of 7 to 8.5 is perfectly acceptable so you are free to use whatever suits you.

A recent article I wrote on the Graham number explains all this in detail.

Now the original Graham’s Formula, not to be confused with the Graham Number, used 8.5 as the no growth PE and Katsenelson uses a PE of 8 in the book.

I on the other hand will stick with my PE of 7.

Why?

If you flip the PE over, you get an earnings yield of 14.2% compared to 11.8% and 12.5% for Graham and Katsenelson respectively.

With the small caps I analyze and the fact that the Graham’s formula produces optimistic valuation numbers, demanding an earnings yield of 14.2% is better than 11.8%.

In a bullish market, demanding a 14.2% return is unrealistic, but that doesn’t mean I have to compromise.

It’s simply a criteria that I’m happy with and something that works for me.

Now, if you mainly focus on analyzing large caps such as MSFT, XOM, or GE, it’s ok to keep the PE to 8.5.

Stock valuation is subjective and all depends on your interpretation. If you have a good thesis on why you are using a certain number, that is 100% ok.

Principal #2: Understand the Earnings Growth and PE Relationship

Logically, higher growth rates leads to a higher PE.

I recall vaguely in a Peter Lynch book mentioning that he considers

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