World’s Simplest Stock Valuation Measure Put to the Test

World’s Simplest Stock Valuation Measure Put to the Test

 

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

 

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:

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 wrong… but it can provide a jumping-off point for due diligence.

Potential Buys

company ticker eps_eg5 PE
Seagate Technology PLC STX

37.94

4.3

US Airways Group, Inc. LCC

38.5

4.9

China Xiniya Fashion Ltd (ADR) XNY

12

2.6

Exide Technologies XIDE

15

3.4

HollyFrontier Corp HFC

31.19

5.3

First Solar, Inc. FSLR

20

4.2

Xerium Technologies, Inc. XRM

20

4.3

YPF SA  (ADR) YPF

13.69

3.9

Newmont Mining Corporation NEM

54.68

9.6

Western Digital Corp. WDC

20.84

5.1

Gulfport Energy Corporation GPOR

48

9.1

Delta Air Lines, Inc. DAL

17.25

4.9

KKR & Co. L.P. KKR

22.43

5.7

Dana Holding Corporation DAN

31.56

7.1

Perfect World Co., Ltd. (ADR) PWRD

9.78

4

Marathon Petroleum Corp MPC

25.16

6.3

Stoneridge, Inc. SRI

35.2

7.8

GT Advanced Technologies Inc GTAT

11

4.2

Telecom Argentina S.A. (ADR) TEO

11.3

4.3

SUPERVALU INC. SVU

11.1

4.3

 

Potential Sells

Company Ticker

eps_eg5

PE

Rubicon Technology, Inc. RBCN

15

125.6

NetSuite Inc. N

34.79

204.1

Amazon.com, Inc. AMZN

30.02

190.6

Clear Channel Outdoor Holdings CCO

24.04

175.5

Servicesource International In SREV

27

192.1

Wright Medical Group, Inc. WMGI

9.43

117.1

Lamar Advertising Co LAMR

4

96.8

Cogent Communications Group, I CCOI

17

170.5

Shutterfly, Inc. SFLY

18.75

182.6

Lattice Semiconductor LSCC

11.5

165.3

Conceptus, Inc. CPTS

17.5

201.6

Cepheid CPHD

20

225

Black Diamond Inc BDE

2.33

146.9

Quidel Corporation QDEL

17.5

421.5

WebMD Health Corp. WBMD

15

485.1

SL Green Realty Corp SLG

-3.09

230.2

Diana Shipping Inc. DSX

-16.62

11.4

Netflix, Inc. NFLX

16.96

803.8

Citi Trends, Inc. CTRN

10.67

942.7

Weatherford International Ltd WFT

-30.72

11.4

That’s all for now.

 

By David Merkel, CFA of alephblog




About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.