04 November 2006

The Value Gauge

The Value gauge score depends on the current and past values for the following metrics:
The gauge value is determined by calculating a score for each of the five items listed above and described below.  A weighted average of the scores is scaled to set its minimum value at zero and its maximum value at 25 points.

Please note there is an overriding zero-point floor and a five-point ceiling for each score component.

Trailing Price/Earnings

A company's Price/Earnings ratio will fluctuate based on investors' assessment of its future prospects.  A sign investors may be undervaluing the company is a P/E at, or below, the low end of the historic range for that company.  Similarly, higher-than-normal P/E values might be an indication of excessive optimism among investors.

A company gets Trailing P/E value points when its current P/E ratio is less than its median value over the last 16 quarters.

Score = (-10) * [(P/E) / (Median P/E)] + 10

If the P/E is 50 percent of its median value, or less, the company gets 5 points.

Trailing Price/Earnings vs. S&P 500 P/E

Company-specific news, such as the success or failure of a new product, will understandably lead to swings in the company's Price/Earnings because it is clear that earnings will grow more or less robustly as a result.  However, changes that affect all companies in an industry or all companies that operate in a particular market can also significantly influence future earnings and, therefore, P/E ratios.

For example, rising interest rates tend to slow economic activity, reducing sales and profits, and also cut the present value of future earnings.

Comparing a company's P/E ratio to the P/E ratio of the overall market, as represented by the S&P 500 index, is one way to filter out the broader factors that affect valuations. When a company's P/E is, say, 10 percent higher the S&P P/E, the company's shares are said to trade at a 10 percent premium to the market.  Similarly, a company P/E that is only 90 percent of the market P/E represents a 10 percent discount.

A lower-than-normal premium, or a greater-than-normal discount, could be indicative of an undervaluation.  We award value points when the ratio of the company's P/E to the market's P/E is less than its median value over the last 16 quarters.

Score = (-10) * [(Current P/E relative to S&P) / (Median P/E relative to S&P)] + 10

If a company's current P/E is 80 percent of the S&P 500's P/E (i.e., a 20 percent discount), but the median ratio is a 10 percent premium, then the score would be:

(-10) * [(0.8) / (1.1)] + 10 = 2.7 points

Many investors consider a low PEG, which indicates that the Price/Earnings is modest relative to earnings growth, to be an important sign of undervaluation. 

The PEG ratio is found by dividing the P/E ratio by the earnings growth rate in percent.  For example, the PEG would be 1.0 when the P/E is 12 and earnings are growing by 12 percent.

The PEG is especially useful if the denominator is the rate the company's earnings will grow in the future.  At GCFR, we're leery of projected earning growth rates, we don't assign any credibility to published five-year forward growth rates.

We've used to the trailing one-year earning growth rate in our PEG calculations, but we have been unsatisfied by the results.  One-time gains and losses make the PEG values erratic.

Instead, after much experimentation, we've settled on using the four-year average rate of growth in Operating Profit after Taxes as the earnings growth rate in the PEG calculations.

We award value points when the PEG is low as determined by this equation:

Score = 5 - [4*(PEG-0.75)]

As usual, the score is limited to a range between 0 and five points.

A PEG less than or equal to 0.75 earns the full five points, and PEG ratios greater than 2.0 get none.

A lower-than-normal Price/Revenue ratio may also be a sign value.  For this reason, we give the company value points when its Price/Revenue ratio is less than its median value over the previous 16 quarters.

Score = (-10) * [(Price/Revenue / (Median Price/Revenue)] + 10

If the Price/Revenue is 50 percent of its median value, or less, the company gets 5 points.

Enterprise Value/Cash Flow
Enterprise Value/Cash Flow is similar to Price/Cash Flow from Operations, but it substitutes Enterprise Value for Market Value.

Enterprise Value is Market Value, plus Debt (long- and short-term), minus the company's Cash and Short-term Investments.  EV is considered a better estimate of the cost to a corporate acquirer than the Market Value because the acquirer is assuming the debt, less any cash on hand that can be used to pay off the debt.

We give the company value points when its EV/CFO ratio is less than its median value over the previous 16 quarters.
Score = (-20) * [(EV/CFO / Median EV/CFO)] + 20

The five-point maximum score is attained when the EV/CFO ratio is 75 percent or less than its median value.

Determining the Value Score
We use the following weights for the different Value score components.

The Value score is 5 * (the sum of each component's score multiplied by its weight) / (100, the total of the weights).

Note: This post was last updated on 1 August 2010.

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