Value investors are concerned with determining what’s called the intrinsic value of the companies they wish to invest in. This intrinsic value nearly always differs from the actual trading price of the stock, presenting us with opportunities to buy for less than the company is really worth! See my recent article, “What is the difference between price and value?” for more on this topic. Today we’ll look at one of the popular methods of calculating intrinsic value using an estimated EPS growth rate and future PE ratio. This is called the EPS Growth Capitalization method and is detailed below.
Recommended reading: It’s recommended you read prior articles, “How to estimate future EPS growth rates” and “How to estimate future PE ratios” as these will come into play in the methods described in this article. Intrinsic value determination is one of the key steps in our Value Investing workflow.
As value investors, we wish to invest in the stock of companies which are going to grow for the foreseeable future. Obviously if the stock price is growing, the price will be some amount higher than it is today. As a starting point, we are going to use a method to try to predict what that future stock price will be. We could be looking any number of years into the future, but typically we are interested in between 5 and 10 years down the road. For one, it’s easier to estimate the behavior of the stock in the near future, than it would be for say 20 – 30 years from now.
Once we have a prediction for the future stock price, we work backwards to determine how much the stock is worth today. That “worth” is what we call the stock’s intrinsic value. The concept here is that if we purchase the stock for a price less than or equal to it’s intrinsic value, then we are guaranteed a certain minimum rate of return on our investment, assuming of course that all of our estimates and predictions of future behavior were correct. Since none of us has a crystal ball, we make sure to apply a margin of safety to our intrinsic value, in an attempt to protect against inaccuracies in our calculations.
EPS Growth Capitalization Method
It’s easiest to explain this valuation procedure by means of an example. We are going to use actual numbers for an intrinsic value calculation recently done for Rue21, Inc. (RUE), a popular retailer exhibiting strong, consistent growth. Our complete analysis of this company can be found here.
Step 1: Determine Future Stock Price
Our first step in determining the intrinsic value of rue21 is to determine what it’s stock price will be in the future. We are going to use a timeframe of 5 years from now for the purposes of this example. Given EPS and a PE ratio, stock price can easily be calculated for any company. The trick here however, is that it is the future EPS and future PE that we’re interested in.
Our first task is to figure out what rue21’s EPS will be in 5 years time. We’ll do this by using today’s EPS as a starting point and applying a compounded growth rate to it for a total of 5 years. Using the methods outlined in this article, I estimate the EPS growth rate for rue21 to be 19%, compounded annually over the next 5 years. The current EPS (ttm) for rue21 as of today is $1.67. Our determination of future EPS is then quite simple using a future value calculation:
F = P(1+R)N
- F = the future EPS
- P = the starting (present) EPS ($1.67)
- R = compound growth rate (19% or 0.19)
- N = number of years in the future (5)
Plugging these numbers in gives us a future EPS of $3.99. Alternatively we could have used Microsoft excel to calculate this for us, using the FV function. Next, we need to determine an estimate of what the future PE ratio will be in 5 years time, using the methods outlined in this article. I estimate that a PE ratio of 20 would be appropriate.
We now have all of the information we need to calculate the future stock price. We simply use:
P = EPS x PE
- P = future stock price
- EPS = future EPS ($3.99)
- PE = future PE (20)
This results in an estimated future stock price of $79.70 in five years time.
Step 2: Calculate Today’s Intrinsic Value
One of the hardest ideas to grasp in this process is the reasoning behind how we work backwards from the future stock price we calculated above, to arrive at something useful – a present day intrinsic value. The reason we need to convert this to present day is because we need a number that we can compare to the price that the stock is trading at today. That future stock price isn’t any good to us in its current form because it’s based on five years from now and there’s been a lot of growth applied to it during that time. And that’s the key – we need to work backwards and remove that growth from the future stock price to see what it’s equivalent value is today.
As complicated as that sounds, this is actually the easiest part of the whole process, because we as the investors get to decide the growth rate to remove – and is called the discount rate. The rate chosen will directly affect the intrinsic value that we calculate, and has the following meaning:
If we purchase the stock at exactly the price that we calculate as the intrinsic value, hold the stock for the entire investment period (in this case 5 years), and our prediction of future stock price was correct, then the compounded investment return we receive will be equal to the discount rate.
Wow – that was a mouthful. In simpler terms it means that we choose the minimum growth rate we will accept. This in turn dictates the highest price we can pay for the stock and still achieve that growth rate. Because of this use, the rate is usually called the minimum acceptable rate of return (MARR). Typical MARRs range from 10% to 15%. For this example we’ll choose the latter. Choosing a lower rate will result in a higher intrinsic value and vice versa for a higher rate. To calculate intrinsic value we use the following present value calculation:
P = F / (1+R)N
- P = present (intrinsic) value
- F = future stock price ($79.70)
- R = MARR (15% or 0.15)
- N = number of years (5)
Running the numbers results in an intrinsic value of $39.63 per share. This could also be calculated using Microsoft excel using the PV function.
Step 3: Apply a Margin of Safety
The intrinsic value of $39.63 per share for rue21 that we arrived at is nothing more than an educated guess based on assumptions we made about the future prospects of the company and to a lesser extent, the stock market in general. It is not an exact science! It would therefore be prudent to attempt to protect ourselves against any deviations the stock makes from our estimates. We do so by giving our target entry price a margin of safety (MOS), accomplished by applying a discount to the intrinsic value.
How big should the MOS be? One simple method is to apply an arbitrary discount, say 50%, to the intrinsic value. In this particular case, that would result in a target entry price of $19.81 ($39.63 x 50%). While simple, I prefer more to base the size of the safety margin on the level of confidence we have in the assumptions we made. If we are 95% sure that the estimates we made in determining the intrinsic value are correct, then it makes sense to use a small MOS. On the other hand if it’s a 50/50 chance we’re correct, maybe it makes sense to be more cautious and use a bigger margin. Typical safety margins range from 50% to 15%. A large margin can severely limit the number of buying opportunities that there are, since stock price must usually drop to extremely low levels to trigger an entry.
It often helps to experiment with different scenarios of EPS growth rates and future PE to see how intrinsic value is affected. In our rue21 example, it’s totally possible that PE could be 15 in the future instead of the PE of 20 we predict. Along the same lines, the professional analyst consensus for EPS growth is only 17% compared to our 19%. Running the calculations again using these numbers gives us an intrinsic value of $27.31 / share. This is 31% less than the original value we calculated and illustrates just how much things can change if we are off on our inputs to the calculations.
Based on this analysis, it is probably reasonable to round the MOS up to an even number, say 35% and use that as the basis for setting the target entry price. Doing so results in a target of $25.76 / share ($39.63 x (1 – 0.35)).
One tip – don’t attempt to be overly conservative while estimating EPS growth and PE. Try to use what you truly believe the real growth and price multiple will be. Use the MOS to account for any misjudgment, otherwise you are applying safety factors to safety factors and will end up with very few – if any, buying opportunities.