I recently came across another variant on the old standby price-to-earnings ratio valuation method. The particular variant is called the Absolute P/E and is detailed by Vitaliy Katsenelson in his book Active Value Investing and was brought to my attention by Jae Jun’s excellent Old School Value newsletter.
The basic idea is to adjust the P/E ratio to take into account several forward looking variables and determine what P/E ratio the stock should be trading at.
The variables are earnings growth, dividend yield, business risk, financial risk, and earnings predictability. The model is:
Absolute PE = (Earnings Growth Points + Dividend Points) x [1 + (1 - Business Risk)] x [1 + (1 - Financial Risk)] x [1 + (1 - Earnings Visibility)]
The value for earnings growth is determined by starting with a no growth P/E of 8 and adding .65 points for every 100 basis point increase in the projected growth rate up until 16%. After 16% you add .5 points for every 100 basis points in projected growth.
The value of the dividend yield is simply the yield expressed in P/E points, for example a 3% yield equals 3 P/E points.
The values for business risk, financial risk, and earnings visibility are all expressed as percent with companies that are riskier getting higher values and those that are less risky receiving lower values. For instance a company with low business risk like Coca-Cola might receive a value of .9 or .95 while a cyclical company with a high business risk might receive a value of 1.2.
I thought it would be interesting to apply this new twist on the P/E ratio to a few companies in the Buffett-Munger screener. I choose the top five companies that appear in the screener but I then decided to remove ITT Education (ESI), Telefonica (TEF), and Express Scripts (ESRX). I removed ESI because of the intense regulatory risk around the company. The absolute P/E ratio method won’t tell us much about the regulatory risk. Telefonica was removed because it reports results in euros and a large portion of its debt is denominated in euros and its valuation is more a reflection of the outcome of the eurozone debt crisis than any other issue. Finally, I chose to exclude ESRX because of the ongoing merger efforts with Medco.
That left us with Humana (HUM, Financial), EZCorp (EZPW, Financial), Bio-Reference Labs (BRLI, Financial), General Dynamics (GD, Financial), and Lockheed Martin (LMT, Financial) as the top five.
So let’s see how they look using the Absolute P/E valuation method.
For the earnings yield projections I took the lowest of the 5 or 10 year net income, EBITDA, or EPS growth rate.
Humana (HUM)
Humana is a mid size health and benefits company. There are many competitors smaller than Humana and a few twice its size. The company has a solid balance sheet (as is expected for this type of company) and earns high returns on capital. I gave it a 1 for financial risk, and a slight deduction ( .05) for earnings predictability as earnings dipped during the recession. The business risk factor was a harder decision.
For-profit third party health benefits and health insurance companies have been proven in study after study to offer poorer coverage at higher prices than single payer health care systems. The healthcare system in the US is grossly inefficient and companies such as Humana play a big role in that inefficiency. I gave Humana a 1.3 for business risk because ultimately it is unlikely the US can continue on its existing path with regards to providing healthcare services. Disagree? Changing the 1.3 to 1 yields a P/E of around 18 versus the 14.23 shown below.
Currently trading at a P/E of 11.2, Humana looks like it could be a deal but it depends on your view of healthcare in the US.
EZCORP (EZPW)
EZCorp operates a chain of pawn shops in the US and Mexico as well as offering short term consumer loans. With the economy in the toilet it’s no surprise EZCorp has shown strong growth with five year EBITDA growing by 23.9% compounded. ROI is excellent at 23.9%. The monkey wrench in the valuation is business risk. Short term consumer loan companies are highly unpopular with state regulators and there are always efforts by regulators as well as consumer groups to rein in what they perceive as predatory lending practices (I happen to side with the consumer groups on this issue).
I gave EZCorp at 1.5 for business predictability and a 1.1 for earnings visibility as the recession has provided a huge tailwind to recent results.
EZCorp currently trades at a P/E of 10.88 which is approximately the value we came up with. Looks like the market agrees that the regulatory risk and tailwind created by the recession mean EZCorp should trade at a discount.
Bio-Reference Labs (BRLI)
BRLI provides laboratory testing services primarily to customers in the New York metro area. The company has grown rapidly (23.3% five year compounded EBITDA growth) and is in an attractive business (ROI of 17.5%).
The company competes with much larger rivals such as Quest Diagnostics and Laboratory Corp. of America so it gets a 1.1 for Business Risk.
BRLI currently trades at a P/E of 12.59 so the absolute P/E model agrees with the Buffett-Munger screener that BRLI looks undervalued.
General Dynamics (GD)
General Dynamics is a large defense contractor and civil aviation (Gulfstream jets) company. Berkshire-Hathaway recently initiated a stake in GD and Buffett has mentioned publicly that he liked the company so we should expect to see it come up as undervalued.
Growth rates are much lower than the other companies we looked at, coming in at 8.73% five year compounded growth in net income. ROI is good at 16.3%.
General Dynamics loses points in earnings predictability because of the recent chatter regarding cuts to the Department of Defense budget.
Current at a P/E 9.25, GD looks undervalued. The absolute P/E model sees the same thing Buffett himself saw.
We profiled General Dynamics in the October 2011 issue of the Buffett-Munger Newsletter.
Lockheed Martin (LMT)
Lockheed Martin is one of the world’s largest defense contractors and the prime contractor for the always in the news Joint Strike Fighter (JSF) program.
We give LMT a 10% bonus for being the prime contractor of the only fifth generation fighter in production (although not yet in service) in the world. That’s quite a monopoly, even if LMT still has some kinks to work out in the program.
Again we deduct points for earnings visibility because of uncertainty of the Department of defense budget.
LMT currently trades at a P/E of 10.15 and just like GD looks undervalued.
Conclusion
The absolute P/E model is good addition to any investor’s toolbox. Like all valuation methods though the usual caveat that they depend heavily on forward looking assumptions still applies. Of course, what valuation method doesn’t use any forward looking assumptions at all?
The Buffett-Munger screener is designed to find Buffett-type investments with extraordinary profitability, consistency, and future prospects. Our monthly Buffett-Munger Best Bargains Newsletter picks one stock from the screener. Our in-depth analysis shares with you why a younger Buffett and Munger would like this stock. If you are a premium member, you can download it here. If you are not, we invite you for a 7-day Free Trial.
Disclosure: Long LMT
The basic idea is to adjust the P/E ratio to take into account several forward looking variables and determine what P/E ratio the stock should be trading at.
The variables are earnings growth, dividend yield, business risk, financial risk, and earnings predictability. The model is:
Absolute PE = (Earnings Growth Points + Dividend Points) x [1 + (1 - Business Risk)] x [1 + (1 - Financial Risk)] x [1 + (1 - Earnings Visibility)]
The value for earnings growth is determined by starting with a no growth P/E of 8 and adding .65 points for every 100 basis point increase in the projected growth rate up until 16%. After 16% you add .5 points for every 100 basis points in projected growth.
The value of the dividend yield is simply the yield expressed in P/E points, for example a 3% yield equals 3 P/E points.
The values for business risk, financial risk, and earnings visibility are all expressed as percent with companies that are riskier getting higher values and those that are less risky receiving lower values. For instance a company with low business risk like Coca-Cola might receive a value of .9 or .95 while a cyclical company with a high business risk might receive a value of 1.2.
I thought it would be interesting to apply this new twist on the P/E ratio to a few companies in the Buffett-Munger screener. I choose the top five companies that appear in the screener but I then decided to remove ITT Education (ESI), Telefonica (TEF), and Express Scripts (ESRX). I removed ESI because of the intense regulatory risk around the company. The absolute P/E ratio method won’t tell us much about the regulatory risk. Telefonica was removed because it reports results in euros and a large portion of its debt is denominated in euros and its valuation is more a reflection of the outcome of the eurozone debt crisis than any other issue. Finally, I chose to exclude ESRX because of the ongoing merger efforts with Medco.
That left us with Humana (HUM, Financial), EZCorp (EZPW, Financial), Bio-Reference Labs (BRLI, Financial), General Dynamics (GD, Financial), and Lockheed Martin (LMT, Financial) as the top five.
So let’s see how they look using the Absolute P/E valuation method.
For the earnings yield projections I took the lowest of the 5 or 10 year net income, EBITDA, or EPS growth rate.
Humana (HUM)
Humana is a mid size health and benefits company. There are many competitors smaller than Humana and a few twice its size. The company has a solid balance sheet (as is expected for this type of company) and earns high returns on capital. I gave it a 1 for financial risk, and a slight deduction ( .05) for earnings predictability as earnings dipped during the recession. The business risk factor was a harder decision.
For-profit third party health benefits and health insurance companies have been proven in study after study to offer poorer coverage at higher prices than single payer health care systems. The healthcare system in the US is grossly inefficient and companies such as Humana play a big role in that inefficiency. I gave Humana a 1.3 for business risk because ultimately it is unlikely the US can continue on its existing path with regards to providing healthcare services. Disagree? Changing the 1.3 to 1 yields a P/E of around 18 versus the 14.23 shown below.
| Absolute P/E Model (Humana:HUM) | ||
| P/E Adjustment | ||
| Earnings Growth | 19.97% | 20.4 |
| + | ||
| Dividend Yield | 1.1% | 1 |
| = | ||
| Starting P/E | 21.4 | |
| Risk Adjustments | x | |
| Business Risk Factor | 1.3 | [1+(1-1.3)] |
| X | ||
| Financial Risk Factor | 1 | [1+(1-1)] |
| X | ||
| Earnings Predictability | 1.05 | [1+(1-1.05)] |
| = | ||
| Absolute P/E | 14.23 |
Currently trading at a P/E of 11.2, Humana looks like it could be a deal but it depends on your view of healthcare in the US.
EZCORP (EZPW)
EZCorp operates a chain of pawn shops in the US and Mexico as well as offering short term consumer loans. With the economy in the toilet it’s no surprise EZCorp has shown strong growth with five year EBITDA growing by 23.9% compounded. ROI is excellent at 23.9%. The monkey wrench in the valuation is business risk. Short term consumer loan companies are highly unpopular with state regulators and there are always efforts by regulators as well as consumer groups to rein in what they perceive as predatory lending practices (I happen to side with the consumer groups on this issue).
I gave EZCorp at 1.5 for business predictability and a 1.1 for earnings visibility as the recession has provided a huge tailwind to recent results.
| Absolute P/E Model (EZCORP:EZPW) | ||
| P/E Adjustment | ||
| Earnings Growth | 23.9% | 22.4 |
| + | ||
| Dividend Yield | n/a | 0 |
| = | ||
| Starting P/E | 23.4 | |
| Risk Adjustments | X | |
| Business Risk Factor | 1.5 | [1+(1-1.5)] |
| X | ||
| Financial Risk Factor | 1 | [1+(1-1)] |
| X | ||
| Earnings Predictability | 1.1 | [1+(1-1.1)] |
| = | ||
| Absolute P/E | 10.08 |
EZCorp currently trades at a P/E of 10.88 which is approximately the value we came up with. Looks like the market agrees that the regulatory risk and tailwind created by the recession mean EZCorp should trade at a discount.
Bio-Reference Labs (BRLI)
BRLI provides laboratory testing services primarily to customers in the New York metro area. The company has grown rapidly (23.3% five year compounded EBITDA growth) and is in an attractive business (ROI of 17.5%).
The company competes with much larger rivals such as Quest Diagnostics and Laboratory Corp. of America so it gets a 1.1 for Business Risk.
| Absolute P/E Model (Bio-Reference Laboratories:BRLI) | ||
| P/E Adjustment | ||
| Earnings Growth | 23.3% | 21.9 |
| + | ||
| Dividend Yield | n/a | 0 |
| = | ||
| Starting P/E | 21.9 | |
| Risk Adjustments | X | |
| Business Risk Factor | 1.1 | [1+(1-1.1)] |
| X | ||
| Financial Risk Factor | 1 | [1+(1-1)] |
| X | ||
| Earnings Predictability | 1 | [1+(1-1)] |
| = | ||
| Absolute P/E | 19.71 |
BRLI currently trades at a P/E of 12.59 so the absolute P/E model agrees with the Buffett-Munger screener that BRLI looks undervalued.
General Dynamics (GD)
General Dynamics is a large defense contractor and civil aviation (Gulfstream jets) company. Berkshire-Hathaway recently initiated a stake in GD and Buffett has mentioned publicly that he liked the company so we should expect to see it come up as undervalued.
Growth rates are much lower than the other companies we looked at, coming in at 8.73% five year compounded growth in net income. ROI is good at 16.3%.
General Dynamics loses points in earnings predictability because of the recent chatter regarding cuts to the Department of Defense budget.
| Absolute P/E Model (General Dynamics:GD) | ||
| P/E Adjustment | ||
| Earnings Growth | 8.73% | 13.85 |
| + | ||
| Dividend Yield | 2.83% | 3 |
| = | ||
| Starting P/E | 16.85 | |
| Risk Adjustments | X | |
| Business Risk Factor | 1 | [1+(1-1)] |
| X | ||
| Financial Risk Factor | 1 | [1+(1-1)] |
| X | ||
| Earnings Predictability | 1.1 | [1+(1-1.1)] |
| = | ||
| Absolute P/E | 15.165 |
Current at a P/E 9.25, GD looks undervalued. The absolute P/E model sees the same thing Buffett himself saw.
We profiled General Dynamics in the October 2011 issue of the Buffett-Munger Newsletter.
Lockheed Martin (LMT)
Lockheed Martin is one of the world’s largest defense contractors and the prime contractor for the always in the news Joint Strike Fighter (JSF) program.
We give LMT a 10% bonus for being the prime contractor of the only fifth generation fighter in production (although not yet in service) in the world. That’s quite a monopoly, even if LMT still has some kinks to work out in the program.
Again we deduct points for earnings visibility because of uncertainty of the Department of defense budget.
| Absolute P/E Model (Lockheed Martin:LMT) | ||
| P/E Adjustment | ||
| Earnings Growth | 2.93% | 9.95 |
| + | ||
| Dividend Yield | 4.94% | 5 |
| = | ||
| Starting P/E | 14.95 | |
| Risk Adjustments | X | |
| Business Risk Factor | .9 | [1+(1-.9)] |
| X | ||
| Financial Risk Factor | 1 | [1+(1-1)] |
| X | ||
| Earnings Predictability | 1.1 | [1+(1-1.1)] |
| = | ||
| Absolute P/E | 14.8 |
LMT currently trades at a P/E of 10.15 and just like GD looks undervalued.
Conclusion
The absolute P/E model is good addition to any investor’s toolbox. Like all valuation methods though the usual caveat that they depend heavily on forward looking assumptions still applies. Of course, what valuation method doesn’t use any forward looking assumptions at all?
The Buffett-Munger screener is designed to find Buffett-type investments with extraordinary profitability, consistency, and future prospects. Our monthly Buffett-Munger Best Bargains Newsletter picks one stock from the screener. Our in-depth analysis shares with you why a younger Buffett and Munger would like this stock. If you are a premium member, you can download it here. If you are not, we invite you for a 7-day Free Trial.
Disclosure: Long LMT
