Fundamental Analysis: Value Price

Fundamental Analysis: Value Price

Value Price is also frequently called Fundamental Value or Intrinsic Value. It is ordinarily calculated by summing the future income generated by the asset, and discounting it to the present value.

"Value Price" and "Intrinsic Value" are synonyms, they all mean "value of a business regardless of the price it is selling for on the market". You may see any of those terms on stock2own.com. We will try to stick with "Value Price" term, but keep in mind - both of them have the same meaning.

Phil Town in his book "Rule #1" says: "The Sticker Price of any business is based on its future EPS and future PE. In other words, if we can figure out what a company's future EPS and PE numbers are going to be in, say, ten years, we can multiply those two numbers together and determine its future price in ten years and than, from that, work backwards to determine its Sticker Price today."

In the Stock Analyzer you can find 4 projection types for each computation: Pessimistic, Moderate, Optimistic and "My Numbers". You shall find the difference between used algorithms in this article. For some companies the final numbers will be the same, for others, the numbers may be quite different. Every time when Stock Analyzer adjusts algorithm for the specific computation type, it will produce a descriptive note, which you can find at the bottom of the Value Price section.

Input Values

Current EPS

We do not have to do any fancy calculations to get the current EPS, which reported on most financial websites and easy to obtain.

Estimated Future EPS Growth Rate

First of all, EPS Growth Rate is an estimate. Phil Town calls it also "the Rule #1 Growth Rate".

Phil Town says: "It makes sense that to predict the future EPS growth rate on a business, we have to look at historical growth rates to base our decisions." And very important: "future EPS growth is actually NOT the historical EPS growth rate, but rather historical equity growth rate."

In order to calculate Estimated Future EPS Growth Rate we have to analyze the following numbers:

• Historical Equity Growth Rate - calculated as an average of all available historical Equity Growth Rates (Stock Analyzer, "Growth Rates" section, row "Equity").
• Historical EPS Growth Rate - Analyst Recommendations provided by Zacks Investment Research. You can find this value in the moneycentral.msn.com, "Earnings Estimates", "Earnings Growth Rates" section, "Last 5 Years" value.
• Forward EPS Growth Rate - Analyst Recommendations provided by Zacks Investment Research. You can find this value in the moneycentral.msn.com, "Earnings Estimates", "Earnings Growth Rates" section, "Next 5 Years" value.

For Pessimistic projection we calculate Estimated Future EPS Growth Rate as a lesser of the described values, for Moderate and Optimistic projections we calculate it as an average. Also, as a conservative projection, we should not expect Estimated Future EPS Growth Rate to be very high. That is why for Pessimistic computation we limit Estimated Future EPS Growth Rate by 40 and for Moderate by 50.

Future PE

PE is a ratio that helps us convert earning per share into a price per share number. The basic formula is this:

PE * EPS = Price

"A quick rule of thumb for figuring the PE is to double the Rule #1 growth rate. We'll call this the default PE." (Phil Town, "Rule #1")

However, this is not enough. In order to be sure, we need to compare default PE with the historical PE. If the historical and default PE are not the same, we'll use the lower of the two when making calculations. You can find any company's average historical PE on any financial website. Usually, you can find at least 2 numbers in the "Price Ratios" section: PE Ratio High and PE Ratio Low. We are using PE Ratio Low number as more conservative.

In order to calculate Future PE we have to analyze the following numbers:

• Default PE - double the Rule #1 growth rate ([Estimated Future EPS Growth Rate] * 2).
• Historical PE - you can find this value in the moneycentral.msn.com, "Financial Results / Key Ratios", "Price Ratios" section, "P/E Ratio 5-Year Low" value.
  If moneycentral.msn.com does not show Historical PE, we will use lower of "Average PE" values for latest 5 years shown in the "Raw Financial Data" section.
• Forward PE - Analyst Estimates provided by Zacks Investment Research. You can find this value in the moneycentral.msn.com, "Company Report", "Earnings Estimates" section, "Forward P/E" value.

For Pessimistic computation we use the lesser of the Default PE, Historical PE and Forward PE. For Moderate computation we check if the Default PE in the same range as analyst estimates we use the average of these three numbers. If the Default PE is more than twice greater than Historical and Forward PE we will limit Default PE by greater of Historical and Forward PE. For Optimistic computation we use the average of the Default PE, Historical PE and Forward PE.

Table of comparison

# of years

Phil Town says: "Rule #1 uses ten years for the future for two simple reasons:

• The 10-10 Rule: We never buy a business for ten minutes if we are not willing to hold it for ten years.
• Practically: Twenty years is too far into the future to do any sort of reasonable predictions, and five years is too short for a long-term hold.

Rate of Return

"The Rule #1 minimum rate of return is 15 percent per year. The Sticker Price is the maximum amount we can pay and still get that 15-percent return on your money over the next ten years."

"Write that down in your brain: 15 percent is our minimum acceptable return per year. Anything that looks like it's going to pay us less, we do not buy." (Phil Town, "Rule #1)

You can change Rate of Return and run your own numbers, of course. Just adjust rates and click "Calculate" button.

MOS Price, %

MOS Price states for "margin of safety" Price. That is why in most cases MOS Price is 50%. Just like Phil Town says: "Do not forget: we never pay the Sticker Price! We always want to buy a dollar of value for fifty cents."

However, sometimes, especially if you are really confident in the stock, you can change default value of 50% to something more risky, like 30% or even 20%, for example. Go ahead and change this number if you want!

Results

Investment Recovery Time (IRT)

The number of years it would take for a company's cumulative earnings (beginning at a base level of $1.00) to equal the stock's current P/E ratio, assuming that the company continues to increase its annual earnings at the projected growth rate. A Recovery Time of six years, for example, means that it would take six years for an investor to recoup the price paid now for $1 of corporate earnings (the P/E ratio).

Just like PE ratio, investors can use the Investment Recovery Time to compare the value of stocks: if one stock has a P/E twice that of another stock, all things being equal (especially the earnings growth rate), it is a less attractive investment. Basically, the smaller IRT is the better investment it is.

Investment Recovery Time shows the correlation between current market price and EPS. Phil Town, the author of "Rule #1" and "Payback Time" said "A payback time of ten years or less is an attractive price. The Payback Time of less than six years is very attractive. Very."

Future EPS

Once we know the Current EPS and EPS Growth Rate for the defined time period ("number of years"), we can calculate Future EPS using the Growth Rate formula.

Future Price

Once we know the Future EPS, we can figure out the future price of the business per share - the future market price - by using a PE, a multiple of earnings. Simply multiply the future EPS by the future PE.

Value Price

We can figure out what the business's Value Price is today by utilizing our future market price and minimum acceptable rate of return. Again we'll use the Growth Rate formula.

MOS Price

MOS states for Margin of Safety. Do not forget: we never pay the Value Price! We always want to buy a dollar of value for fifty cents.