Valuation is generally the toughest part of fundamental analysis. There are so many methods to value a stock to know whether the stock is currently overpriced , fairly priced or cheaply priced. Here I am showing a very simple valuation method which requires very less calculation.
PE Ratio Stock Valuation Model
To use this method you need
- The forward price multiple or the PE multiple which you expect the market will give to the stock. You can also use the average PE that companies in that sector get.
- The current earning per share (EPS) of the stock. Take the diluted EPS
- Current dividend per share of the stock. Calculate the dividend payout ratio from that
For an example lets take the FMCG company Marico. The average PE of FMCG companies is 40. I will take PE as 40 in the calculations assuming that market will continue to give PE multiple of 40.
The current eps of the company is 5.5 Rs
The current dividend yield 3.2 Rs per share. The dividend payout of Marcio has been varying from 20-50% over the last 5 years period. I take the dividend payout ratio as 30% That means for each 100 Rs of net profit company pays 30 Rs to shareholders as the dividend.
Assuming the company can continue to grow at 20% for the next three years I take the growth rate as 20% . The EPS and the Dividends for the next three years will be.
You can see that at the end of the 3rd year the company will have EPS of 9.5 Rs We can arrive the expected share price by multiplying PE multiple with the EPS. We will get the expected share price 9.5 x 40 = 380
The company will also pay the total dividend of 10.7 Rs adding that to the expected share price we get the new expected share price 390 Rs. This whole calculation tells that after three years the share price can be 390 Rs
At what price we should buy?
The answer to this questions depends on how much return you want. You should discount the expected share price by the rate of return you want from the stock. If I want 20% annual return from the stock I have to discount the share price by 20%. On discounting the price 390 390/(1.20)^3 I get the value 225 . That means for 20% annual return from Marico I should buy it below 225.
I did the calculation for three years if you wish to hold for more than 3 years and expects the company can continue to grow at a good pace for many years you can do the same calculation for 5 years or more also.
To do all these calculations easily you can build an excel sheet. I have built my own excel sheet where I have to enter the stock code and rest all calculations are done by the sheet.
Caution: The results will depend on your estimated PE and growth rate. Desired results won’t come if the PE and growth rate assumptions are not matched.
Abhishek is an Engineer MBA in Finance and Certified Research Analyst. He is an active trader and investor in the stock market since 2010. Follower of the philosophies of Warren Buffet and Peter Lynch in investing and trend following in trading.