I myself do use an arithmetical ratio that combines in one number a company's ROE, p/b, and a Cost of Capital factor.
Paul, Jim, others: Can you give me a back-of-the-envelope guess at what would be a fair value for the following hypothetical (honest, it is!) company?
Let's say you have a traditional mid size industrial company (i.e. a proxy for "traditional accounting is reasonably close to the truth") that has no debt and makes 17% ROE (let's say it has made that it the past and will make that in the future). Let's also say that they grow at or slightly above GNP growth rates. Let's say that a fair cost of capital is 9%.
What is the company worth? (say, expressed as some multiple of book value)
(What I'm really trying to figure out with this question is how to value highly profitable enterprises with moderate (perhaps I should say par) but reasonably certain future prospects).
If I'm simplistic about it and see that the ROE is well in excess of the cost of capital, I could say that any price is justified, since the company is growing shareholder value at a rate of 8% in excess of its cost of capital. Pay up, sit back, shut up, hold on, and let the magic of compounding catch up to your entry price, and then power ahead.
However, though I could be easily convinced that it would be rational to pay a premium to book value, I have not yet signed on to the "no price is too high" school either.
(FWIW, "PEG" would say (assuming a 6% nominal annual growth rate) to pay a P/E of 6, which IMHO is yet another data point on how out-to-lunch PEG is. Try "PEG" on a long bond for something even more stupid - it says bonds are worthless!).
- Daniel |
