Momentum Indicators
Typically relate either price or a fundamental (such as earnings) to the time series of its own past values or, in some cases, to its expected value
Two multiple valuation methods
Method of Comparable, Method based on forecasted fundamentals (like forward P/E)
Method of Comparable
Valuation of an asset based on multiples of comparable (similar) assets, guideline assets, guideline companies. Economic rationale of this method is law of one price. If this method is used, adj is required for cap structure, growth, etc.
Median is used rather than mean value of peer group’s multiple
to avoid distortion from outliers
Drawback in using P/E
Zero, negative or small EPS, managers distorting EPS
Trailing P/E
Current MP / most recent 4 quarter EPS
Forward P/E
Current MP / next 4 qtr EPS
Forward P/E (fiscal years)
Thomson First Call reports a stock’s “forward P/E” in two ways: first, based on the mean of analysts’ current fiscal year (FY1) forecasts, for which analysts may have actual EPS in hand for some quarters, and second, based on analysts’ following fiscal year (FY2) forecasts, which must be based entirely on forecasts
NTM P/E
Current market price divided by an estimated next 12-month EPS, which typically combines the annual EPS estimates from two fiscal years, weighted to reflect the relative proximity of the fiscal year. Facilitates comparison of companies with different fiscal year ends without the need to use quarterly estimates
Normalized P/E
If trailing or forward EPS is negative or unrepresentative of a company’s earning power, however, an analyst may base the P/E calculation on a longer-run expected average EPS value.
Justified P/E (based on forecasted fundamentals)
D0(1+g)/r-g = E0(1-b)(1+g)/(r-g). Forward P/E = (1-b)/(r-g), trailing P/E = (1-b)(1+g)/(r-g)
Predicted P/E
Conceptually similar to a justified P/E, can be estimated from cross-sectional regressions of P/E on the fundamentals believed to drive security valuation. It summarizes a large amount of data in a single equation and can provide a useful additional perspective on a valuation. Limitations are predictive power of the regression for a different stock and different time period is not known, regression coefficients and explanatory power of the regressions tend to change substantially over a number of years.
Adjustment for non-recurring items
Remove non-recurring items (like g/l on asset sale, provisions for future losses, and changes in accounting estimates) often appear in the income from continuing operations portion. Analyst may decide not to exclude income/loss from discontinued operations when assets released from discontinued operations are redirected back into the company’s earnings base
Adjustment for Business-cycle influences
Because of cyclical effects, the most recent four quarters of earnings may not accurately reflect the average or long-term earning power of the business, particularly for cyclical businesses. Analysts address this problem by normalizing EPS (estimating the level of EPS that the business could be expected to achieve under mid-cyclical conditions)
2 methods for calculating normalized EPS for cyclical business
Historical average EPS (Average EPS over the most recent full cycle) or average ROE (Average ROE from the most recent full cycle, multiplied by current book value per share)
Earning yield
Inverse of P/E. Can be used for rankings even if P/E is negative
High P/E justified if
the subject stock has higher-than-average (or higher-than-median) expected earnings growth or lower than average or (lower than median) risk (operating or financial)
PEG ratio
Stock’s P/E divided by the expected earnings growth rate (in percentage terms). Lower PEG ratio the better
Limitation of PEG
Assumes a linear relationship between P/E and growth. The model for P/E in terms of the DDM shows that, in theory, the relationship is not linear. Doesn’t factor in risk. Doesn’t account for difference in duration of growth
Growth stocks tend to have high
Beta than value stock
Fed Model
Considers the stock market to be overvalued when the market’s current earnings yield is less than the 10-year Treasury bond (T-bond) yield. Drawback is that the relationship between interest rates and earnings yields is not a linear one.
Yardeni Model
Incorporates the expected growth rate in earnings—a variable that is missing in the Fed model. CEY = CBY – b × LTEG + Residual, where CEY is the current earnings yield on the market index, CBY is the current Moody’s Investors Service A rated corporate bond yield, and LTEG is the consensus five-year earnings growth rate forecast for the market index. The coefficient b measures the weight the market gives to five-year earnings projections. Although CBY incorporates a default risk premium relative to T-bonds, it does not incorporate an equity risk premium per se. So P/E is inverse
Own Historical P/E
Uses past values of the stock’s own P/E as a basis for comparison. In using historical P/Es for comparisons, analysts should be alert to the impact on P/E levels of changes in a company’s business mix and leverage over time. If the company’s business has changed substantially within the time period being examined, the method based on a company’s own past P/Es is prone to error. Changes in the interest rate environment and economic fundamentals, inflation, changes in a company’s ability to pass through cost inflation to higher prices over time may also affect the reliability of such comparisons.
P/E in Cross-Country Comparisons
Analyst should be aware of the following effects before using P/E for CCC. Effect on EPS of differences in accounting standards, Effect on market-wide benchmarks of differences in their macroeconomic contexts. For two companies with the same pass-through ability, the company operating in the environment with higher inflation will have a lower justified P/E; if the inflation rates are equal but pass-through rates differ, the justified P/E should be lower for the company with the lower pass-through rate.
