An Introduction to Stock Valuation

Note: Please read the disclaimer. The author is not providing professional investing advice.

Note: This is a technique mostly gleamed from Phil Town’s Rule #1 book. If you haven’t a clue how to come up with an estimate of what price per share a given stock should be trading at, this is as good a place as any to start. Know that most institutional investors combine multiple valuation models to arrive at buy/sell target prices.

There are a variety of techniques one can use to determine whether a particular stock is over- or under-valued. And though the movements of the stock market often seem to defy logic, at least in the short term, I thought I’d present an introductory valuation approach that you might find appealing to your logical side.

I’ll do this by example, using a stock I currently own – Tractor Supply Company (ticker TSCO) – which is currently trading at $38.38 per share (November 30, 2008).


Introduction
Just so the newbie doesn’t get lost in the details, here’s an overview of what we’re doing. First we estimate an annual rate of growth for the company’s earnings, based on how they’ve grown in the past. Then we grow the current earnings at that rate in order to predict what the earnings will be at some future date. We then convert that future earnings-per-share into a price-per-share via the expected P/E ratio (which is also based on the past). Finally, we figure out what price we’d have to buy at today in order to reach that future price while earning our desired rate of return.

Step #1: Find current EPS
The first step is just to locate the company’s most recent 4 quarters of earnings, known as the trailing-twelve-months (TTM) earnings-per-share (EPS). We can easily grab this popular statistic from any financial website. Today I went to the Key Statistics page of Yahoo Finance and read a diluted EPSTTM=$2.52 for Tractor Supply.

Step #2: How will earnings grow over the next 10 years?
In this step, we’re looking for an estimate of the earnings growth rate. We can get this estimate from a variety of places, but we’ll start with the stock’s historical growth rates. This MSN Money link will give you a quick overview of the past 10 years.

Looking at the most recent and most distant entries in time, we see that sales (in millions) were $2703 in 2007, and $601 in 1998. This is an annualized growth rate of about 18%.

Sales Growth Rate = ($2703 / $601)1/9 – 1 = .1818 or 18%

Next we repeat the same calculation, but this time over historical EPS instead of sales. This yields an annualized growth rate of about 21%

Earnings Growth Rate = ($2.40 / $0.42)1/9 – 1 = .2137 or 21%

Finally, we compute the growth rate of equity (book value per share). These historical numbers are found on a different MSN money page and show an annualized growth rate of approximately 18%.

Equity Growth Rate = ($15.08 / $3.43)1/9 – 1 = .1788 or 18%

We might also check in with what the analysts are predicting about TSCO’s future long-term growth rate . See the third line item from the bottom (entitled “Next 5 Years”) here. Today the average of the analysts’ predictions is about 15%.

Average of Analysts’ Predicted Long-Term Growth Rate = 15%

So of all the above 4 growth rates (18%, 21%, 18%, and 15%), which provides the best estimate as to how earnings will grow in the future? You could average them, but a good conservative choice is just to pick the minimum. This turns out to be 15%.

Step #3: What will the EPS be in 10 years?
Well if the current EPS of $2.52 grows at our 15% for 10 years, EPS will be

$2.52 x 1.1510 = 10.19

… which turns out to be $10.19 per share.

Step #4: Then what will the price per share be in 10 years?
The same link we used above to find a 10-year history of BV/S also has a 10-year history of Price-to-Earnings. If we now average the 10 entries (you could also use median if there is large yearly variation, or minimum if you’re ultra-conservative) we get that TSCO’s mean P/E over the last 10 years was 16.4. Therefore we use our future EPS and future best guess at P/E to estimate what the stock will be trading at.

Earnings/Share x Price/Earnings = Price/Share
$10.19 x 16.4= $167

Step #5: What minimum return per year do I require earning if I were to buy this stock?
If we’re going to tie up our money for 10 years, we might as well require a good return. 15% seems well worth the sacrifice, without getting too greedy.

Step #6: What price (P) would I have to buy that stock at today to earn my minimum required return?

So we’ll arrive at that future $167 per share price and compound our money at the desired 15% per year if we buy today at…

P x 1.1510 = $167

so…

P = $167 / 1.1510 = $41.28


Step #7: What is my margin of safety?
We know that our above “fair value” estimate of $41.28 per share if we want to make 15% over the next 10 years is just that, an estimate. Therefore investors often look for a so-called margin-of-safety, which can best be defined as a discount to the fair value.

In this case, the difference between the current price per share ($38.38) and our maximum price we’d pay ($41.28) means about a 7% margin of safety, which wouldn’t be enough to trigger a buy for most conservative bargain hunters (who look for something more in range of 33% to 50%).

Final Comments
A critical thinker can immediately come up with potential problems with the above-presented valuation technique. To pick the low hanging fruit I’ll mention three…

• Historical average P/E may be higher than future average P/E, as a company goes from a rapidly expanding start-up to a more mature, slower growing company.

• The annualized growth rates we computed are entirely dependent upon the beginning and end points of the time period over which we’re annualizing. This causes distortions if, for example, our most recent EPS was extraordinary large (due to a non-operating sale of assets or peak of cyclical cycle) and/or our most distant EPS was extraordinarily small (due to trough of a cyclical cycle or middle of a recession). A work-around may be to use linear regression to come up with a “best-fit” growth rate that weights all years equally or smooth earnings over adjacent years before annualizing.

• The minimum required return of 15% that we picked in Step #5 does not need to be fixed for all stocks. Theoretically, the more risky a stock is, the more return you should require from it for taking on that risk. So use a higher discount rate for a Russian small-cap versus a US large-cap. Alternatively, you could just require a greater margin of safety before buying.

Finally, it’s important to remember that to “beat the street” so to speak, by recognizing a bargain before anyone else does, you not only have to be correct in your estimate of future earnings, you also have to be different. Therefore you might want to skip the factoring in of other analysts’ opinion as I did in Step #2 and just trust what you come up with on your own.