The procedure commonly employed by investment analysts to estimate the intrinsic value of a share consists of the following steps:
1. Estimate the expected earnings per share
2. Establish a PE ratio
3. Develop a value anchor and a value range
Estimate the Expected Earnings per share (EPS):
Based on how the company has done in the past, how it is faring currently and how it is likely to do in future, the investment analysts estimates the future (expected) EPS. An estimate of EPS is an educated guess about the future profitability of the company. A good estimate is based on a careful projection of revenues and costs. Analysts listen to what customers say about the products ad services of the company, talk to competitors and suppliers and interview management to understand the evolving prospects of the company.
Note that the EPS forecast is based on a number of assumptions about the behavior of revenues and costs. So the reliability of the EPS forecast hinges critically on how realistic are these assumptions.
As an investor when you look at an earnings forecast, examine the assumptions underlying the forecast. What assumptions has the analyst made for demand growth, market share, raw material prices, import duties product prices, interest rates, asset turnover ad income tax rate? Based on this assessment you can decide how optimistic or pessimistic is the earnings forecast.
It is better to work with a range rather than a single number. Paint a few scenarios – optimistic, pessimistic, and normal – and examine what is likely to happen to the company under these circumstances.
In addition to the EPS, the cash flow per share which is defined as:
Profit after tax + Depreciation and other no cash charges / Number of outstanding equity shares Is also estimated.
The cash flow per share in the above illustration is (75+34)/15 = Rs 7.27. The rationale for using the cash flow per share is that the depreciation charge in the books is merely an accounting adjustment, devoid of economic meaning. Well managed companies, it may be argued maintain plant and equipment in excellent condition through periodic repairs, overhauling and conditioning. As the expenses relating to these are already reflected in manufacturing costs one can ignore the book depreciation charge. This argument, however, may not be valid for all companies. So, you must look into the specific circumstances of the company to judge what adjustments may be appropriate.
Establish a PE ratio:
The other half of the valuation exercise is concerned with the price earnings ratio which reflects the price investors are willing to pay per rupee of EPS. In essence, it represents the market’s summary evaluation of a company’s prospects.
The PE ratio may be derived from the constant growth dividend model, or cross section analysis or historical analysis.
Different PE ratios:
Note that different PE ratios can be calculated for the same stock at any given point in time:
1. PE ratio based on the last year’s reported earnings
2. PE ratio based on trailing 12 months earnings
3. PE ratios based on current year’s expected earnings
4. PE rations based on the following year’s expected earnings
An example may be given it illustrate the different PE ratios. The equity stock of ABC Limited is trading on August 1, 20X5 for Rs 120 and the following EPS data is available:
EPS for last year (April 1, 20X4 – March 31, 20X5): Rs 8
EPS for trailing 12 months (July 1, 20X4 — June 30, 20X5): Rs 8.5
EPS expected for the current year (April 1, 20X5 – march 31, 200X6): Rs 9.0
EPS expected for the following year (April 1, 20X6 – March 31, 20X7): Rs 10.0
The different PE ratios are as follows:
PE ratio based on last year’s reported earnings: 120/8 = 15.0
PE ratio based on trailing 12 months earnings: 120 / 8.5 = 14.1
PE ratio based on current year’s expected earnings: 120 / 9.0 = 13.3
PE ratio based on the following year’s expected earnings: 120 / 10.0 =12
In our discussion we will use the PE ratio based on current year’s expected earnings.