World’s Simplest Stock Valuation Measure Put to the Test

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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.

 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