see post 7125:
INFORMATION REGARDING PEs
I have seen PE ratios thrown around when trying to value a company. I would like to
inform those of you that are not well-versed on PEs, but do have an interest in the merits
and drawbacks of using a PE for valuation purposes.
To begin with, there are different types of PEs. One of the more common ones is the
trailing PE. This calculation uses prior earnings per share and share price. However,
since some companies most recent quarter's are thought to be more representative of
future performance, some people multiply the last quarter's earnings per share by 4
when calculating the PE. Of course, one would not want to do this in a seasonal
business such as retail, when a majority of sales come in November and December (and
a majority of returns in January). So, we not only have different types of PEs, but also
different ways of calculating a PE within each type! Since different sources use different
methods, make certain you understand exactly how the PE is calculated before doing
comparisons.
In general PEs have 2 benefits. First, they are easy to compute. People prefer them for
their simplicity. Second, within a given industry or sector, PEs are usually fairly similar
and thus provide people with a level of confidence in their use. As for the drawbacks,
the PE can be too simple and provide very misleading results in certain cases. An
example below will help people understand the simplicity drawback and better
understand why PEs are dangerous to use with internet-related stocks. Also, Net
Income (which is the base for a PE calculation) can be manipulated by company
management. For example, a president that has his compensation tied to net income
may change the depreciation schedule to a more aggressive one which will improve net
income in the short-run.
The discounted cash-flow method of valuing a company is generally accepted by all
financial analysts. Typically, an analyst (with the assistance of accountants) will forecast
the balance sheet and income statement for a company for 7-10 years. Then, from these
statements, a cash-flow statement can be produced for these future years. Finally, since
money in 7 years is worth less than money today, the analyst uses a discount rate to
reduce each years cash flow. Then, the value of the company is equal to the total value
of the discounted cash flows. It may sound complicated, but it really isn't. One last thing:
as a rule of thumb, the value derived from the company in the years following the 7-10
year projection is approximately the same as for the value within those 7-10 years. It
will be more clear when you see the following example:
Company A has the following cash flows for next 7 years: $30, $36, $43.2, $51.84,
$62.21, $74.65, $89.58 (growth rate of 20%)
Company B looks like this: $30, $54, $97.2, $174.96, $314.93, $566.87, $1020.7
(growth rate of 80%)
The value of Company A in these 7 years is (assuming a discount rate of 18%- a
semi-risky company): $187. ($30/1.18 + $36/(1.18)^2 + $43.2/(1.18)^3 +
51.84/(1.18)^4, etc.
The value of Company B is: $882
Since the value derived from the years after year 7 are roughly the same, Company A
would have a Total Value of $187 x 2 or $374. Company B has a total value of $882 x
2 or $1764. Assuming 100 shares each company. Company A would have a share
price of $3.74 and company B would have a share price of $17.64.
Now, to make things simple, assume that net income and cash flow are roughly equal.
Then, after 1 year, company A and Company B have a net income of $30 and 100
shares, or 30-cents per share. A PE of 20 would yield a share price of $6 for both! So,
what PE should we use?
One last thing. Net income is not the same as cash flow. Cash flow is exactly as it
seems. It is all the cash received during a given period less all the cash paid out during
that same time period. Net income includes many non-cash items (such as depreciation)
and thus to go from net income to cash flow there are several changes that need to be
made.
If you are going to use PEs, I would suggest that in addition to understanding how it is
calculated, that you choose comparable firms. One that has a past that is similar (as that
company's PE is dependent on its past net income), a similar future in terms of growth, a
similar capital structure, etc. You see, it is difficult to find something like this, especially
with internet stocks.
Someone asked me if IDTs PE was a good number for DGIV. Absolutely not. IDTs
past business practice is primarily based on pre-paid calling cards. Second, IDT has
grown up and growth will be more difficult to come by and manage than for DGIV.
Also, IDT has a domestic strategy whereas DGIV has an international strategy for
growth. And although the Domestic market is much larger than the international market,
I would guess that the international market is much more profitable.
My intuition is that DGIV should have a higher PE than IDTC. But, whatever the case,
the real way of valuing a company was described above and not with PEs.
dwlima |
