09-07-2013, 03:52 PM
I like to look at the P/E to know whether the overall market is pricey, but it has some problems. First, using the P/E is an absolute method, meaning half the time you will be above the average, which means you will be tempted not to invest at these times. I try to avoid timing the market by investing every month. Second, you really need to know the average P/E ratio for each stock, which requires an extensive database. The biggest advantage of the P/E ratio is that it can be used for all stocks.
Using a perpetuity equation, the stock value can be determined relative to its major competitor, corporate bonds. This method can be used in up and down markets and can use readily available data. I have a whole set of stocks on a spreadsheet where the calculations are performed. Since the comparison is done based on income, it works well with moderate to high yield stocks, but it doesn't work well with low yield stocks. I read somewhere (I wish I could remember where) that the Federal Reserve compares the total return of stocks compared to corporate bond yields to determine if the stock market is pricey.
Using KO as an example:
Current Price = 38.35
Annual Dividend = 1.12
Debt to Equity Ratio = 109.37%, Book Value = 7.27; therefore, Debt Per Share = 1.0937 x 7.27 = 7.95
Bloomberg Investor Grade Bond Index Yield = 4.2%
July Annualized Inflation Rate = 2.0%
Expected Return = 1.12 x 38.35/(38.35 + 7.95) = 0.93
Discount Rate = 0.042 - 0.02 = 0.022
Current Value = 0.93/0.022 = 42
This would say that KO is approaching its current value.
Using the method to extrapolate the future value from dividend growth does have some aspects of smoke and mirrors; however, I only use the ratio of price to future value for comparison between stocks that have meet the basic screening criteria of price less than current value, dividend growth rate higher than inflation, and payout ratio less than 0.8. I put more reliance on the current value calculation than the future value calculation.
I use a formulaic approach primarily because I don't believe in the precision of fundamental analysis. Fundamental analysis only looks at the finances. Unless you have been working within an industry and company at least 10 years, you really don't know that industry or company. With a formulaic approach, I can invest in a relatively large number of companies with a reasonable effort.
Using a perpetuity equation, the stock value can be determined relative to its major competitor, corporate bonds. This method can be used in up and down markets and can use readily available data. I have a whole set of stocks on a spreadsheet where the calculations are performed. Since the comparison is done based on income, it works well with moderate to high yield stocks, but it doesn't work well with low yield stocks. I read somewhere (I wish I could remember where) that the Federal Reserve compares the total return of stocks compared to corporate bond yields to determine if the stock market is pricey.
Using KO as an example:
Current Price = 38.35
Annual Dividend = 1.12
Debt to Equity Ratio = 109.37%, Book Value = 7.27; therefore, Debt Per Share = 1.0937 x 7.27 = 7.95
Bloomberg Investor Grade Bond Index Yield = 4.2%
July Annualized Inflation Rate = 2.0%
Expected Return = 1.12 x 38.35/(38.35 + 7.95) = 0.93
Discount Rate = 0.042 - 0.02 = 0.022
Current Value = 0.93/0.022 = 42
This would say that KO is approaching its current value.
Using the method to extrapolate the future value from dividend growth does have some aspects of smoke and mirrors; however, I only use the ratio of price to future value for comparison between stocks that have meet the basic screening criteria of price less than current value, dividend growth rate higher than inflation, and payout ratio less than 0.8. I put more reliance on the current value calculation than the future value calculation.
I use a formulaic approach primarily because I don't believe in the precision of fundamental analysis. Fundamental analysis only looks at the finances. Unless you have been working within an industry and company at least 10 years, you really don't know that industry or company. With a formulaic approach, I can invest in a relatively large number of companies with a reasonable effort.