Always question assumptions

 

Always question assumptions

 

By Paul Price of Market Shadows

(Note: this article was originally published in Aug. 2012)

A common way to estimate the future price of any stock is to assign a ‘fair’ price/earnings (P/E) multiple to what you think that company can earn by the end of your chosen time horizon for evaluation – for example, 12 months from today.

If the stock in question is expected to post $1 in year-ahead earnings per share (EPS or “E” in our equation), and you think it merits a 15 P/E… your share price target would be $1 (E) x 15 (P/E) = $15 (Price). Whether that $15 would represent a gain or loss depends on where the shares are presently trading. 

The chance of achieving your goal ($15) is also tied to the accuracy of your assumptions. How did you arrive at a ‘fair’ multiple? What level of confidence do you have that your forward estimate will actually occur?  Your fair P/E estimate could be way too high, your $1 E estimate could also be way too high. 

One good source to shed light on these questions is the Value Line Investment survey. Value Line is a subscription-based independent source of research information that’s been around since 1931.   

One of its best features is shown on the bottom right corner of each of its 1700 individual stock reports. Value Line assigns percentile ranks from 5 – 100 (with 100th being best) regarding three key company attributes: 

Value Line  Metrics

 

 

 

 

The higher the rankings, the more confidence VL has in their own projections. Financial Strength is gauged from ‘C’ to ‘A++’. A company already in default gets a ‘D.’ Good financial strength, lower volatility and high earnings predictability are prized characteristics that often command premium valuations.

Earnings Predictability is the key factor to consider in whether to trust consensus views about estimates. If you see very low percentile rankings in this area, give more than a grain of salt to future earnings when setting price targets. That’s straight forward.

The correct P/E to assume is a much tougher decision. Some analyst use formulas like PEG ratios (G = growth). Others simply arbitrarily assign what they think the company should trade for. I think the best indicator of future behavior is past behavior. Value Line is wonderful in making this data readily available.

Here is an example using well-known money management firm Franklin Resources [BEN].  The FY 2001 – FY 2011 data is what actually occurred – not somebody’s theoretical projections. Over that entire 11-year period, BEN’s average P/E was 17.4x. In the four very subdued stock market years 2008 – 2011, its average multiple was 15.8x.  

BEN 2002 - 2011 per share data       source- Value Line 

 

Why, then, does Value Line assume a 10.5x P/E for its 3 – 5 year projection? Value Line’s out-of-historical-boundaries multiple is so far below past performance numbers that I throw it out as absurd. That’s especially unlikely as Value Line also predicts that BEN’s EPS will grow from 2011’s $8.65, and 2012’s $8.95, to $12.70 over the coming three-five years.  

Value Line’s unsupportably low P/E assumption makes its price target price laughably low, based on its own 2015-17 earnings projections. Even 15 times the longer-term EPS estimate would lead to a $190.50 median share price target!

Value Line also presumes that BEN will trade at a lower relative P/E a few years from now than it averaged during any of the past dozen years. 

Without questioning Value Line’s assumptions, we’d probably think high-quality Franklin Resources stock offered no meaningful potential. That would be wrong.

This next example shows the inconsistency of opinion even within Value Line’s own staff. Off-price retailer TJX Companies [TJX] sported an 11-year average P/E of 15.6x during the eleven years 2001 – 2011. Its more recent 2008 – 2011 multiple averaged only 13.3x. 

TJX   FY 2001 - FY 2011 data    source - Value Line   Aug. 3, 2012

 

In this case, Value Line’s long-term view is based on an assumption of a much more realistic 15x P/E. Value Line’s modest total return projections for TJX seem to be valid based on today’s higher than typical P/E of 18.3x forward estimates for the fiscal year ending Jan. 31, 2013. 

The bottom line? Always question the way target prices have been calculated before deciding to dive into a stock purchase. The rationale for the price goal may be built on quicksand.

As market savvy Edward Yardini said, “You have to figure out how the consensus is wrong to be valuable to a client.” 

Disclosure: Long BEN shares 

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