The Basic Logic
 Starting Point: Stocks should be priced at the present value of expected future cash flows
 Tbis is often impractical due to the extrme and unrealistic forecast burden it presents
 Simpler Formulation: Gordon Dividend Growth Model, P = D/(R – G)

 P = Stock Price
 D = Next Expected Dividend
 R = Required Rate of Return which is based on market interest rates and premiums for assuming (a) the risk of the equity market in general and (b) the unique risks associated with this company
 G = Expected future (infinite) rate of dividend growth

 Practical adaptation to address the reality that dividends are often minor or nonexistent; treat all of Earnings as accruing to shareholders with shareholders implicitly choosing to reinvest all or most earnings back into the business. Substituting E (Earnings) for D, we get:

 P = E/(R – G)
 Rearranging the equation (dividing both sides by E), we get a formula for the ideal P/E
 P/E = 1/(RG)
 This tells us that as G (growth) rises, P/E should rise
 This also tells us that as R (required return) falls, P/E should rise. Therefore, considering the components of R, we know that as Interest Rates fall, P/E should rise, as equity market risk falls, P/E should rise, and as companyspecific risk falls, P/E should rise. Expressing the latter a different way, as Company Quality rises, P/E should rise.
 P/E = 1/(RG)

 It’s not practical to work as if this was a specific formula into which we can plug numbers because realworld estimation (especially the notion of infinite growth) is too difficult
 But we can use these ideas as a theoretical roadmap for developing a stock selection strategy

 Favor stocks that show such data characteristics as to justify a credible assumption that V (Value; P/E and/or other valuation ratios) is too low relative to G (expected future growth) and/or Q (company quality)
 Future growth cannot be quantified; instead, use S (Sentiment) as a proxy for the investment community’s broad expectations regarding the future)
 Hence the overall theme of the strategy: a combination of Value, Quality and Sentiment, or VQS

Refinements
 Looking more closely at R (Required Rate of Return
 Use Capital Asset Pricing Model as a guide
 R = RF + (B * RP)
 RF = Rate of Return on RiskFree Assets
 RP = Risk Premium investors demand in order to invest in a risky asset class (e.g., equities)
 B = Beta, a measure of companyspecific Risk
 Takeaways
 As interest rise, RF rises causing R to rise and, all else being equal, depresses P/E
 As investors become more concerned about the risks associated with equities, RP rises causing R to rise and, , all else being equal, depresses P/E
 As companyspecific risk rises, B rises causing R to rise and, , all else being equal, depresses P/E
 Conversely, reductions in RF, RP or B drag R down and, all else being equal, push P/E upward
 This Framework Encompasses Valuation Ratios Other Than P/E
 Example: Price/Sales
 Earnings = Sales * Margin
 Therefore
 P = E / (RG) = (S * Margin) / (R – G)
 P/S = Margin / (R – S)
 Hence, higher P/S ratios are justified by lower R, greater G and/or higher margins
 Example: Price/Book
 `Earnings = Return on Equioty, or ROE * Book Value
 Therefore
 P = E / (R – G) = (BV * ROE) / (R – G)
 P/B = ROE / (R – G)
 Hence, higher P/B ratios are justified by lower R, greater G and/or higher ROE
 Other ratios can be similarly adapted. Ultimately, an appropriate ratio between the price of a company (price per share, enterprise value, etc.) and a fundamental measure such as Sales, Margin, EPS, Dividend, EBITDA, Cash Flow, etc. is assessed with respect to
 Expected growth of the fundamental characteristic being considered, and
 Required Rate of Return which comprises interest rates, assetclass risk and companyspecific risk.
 Example: Price/Sales
 Price Determination Is Not Always Logical
 Up till this point, we’ve assumed that P=V; i.e., that the price of a stock should be equal to its fair value
 This is oversimplified
 We have to account for market “noise”
 Noise, N, is not something dysfunctional we expect to eradicate with better investor education; it’s a normal and inevitable aspect of the market
 Therefore, P = V + N (Price = Value + Noise)
 Generally speaking . . .
 The easier it is for investors to come up with reasonably credible estimations of value, the less room there will likely be for noise to influence the price. Conversely . . .
 The harder it is to come up with a credible, defensible objective valuation, the more room there is for noise to influence price
 One way to quantify Noise as a percent of market capitalization is to use the following formula
 (MarektCap – (NOPAT/WACC)) / MarketCap where
 NOPAT os Net AfterTax Operating Profit
 Operating Profit * (1 – Tax Rate)
 WACC = Weighted Average Cost of Capital (as a practical matter, this is often a judgment call)
 NOPAT os Net AfterTax Operating Profit
 This is described more fully in one section of the Strategy Design Course
 Click here for a simple summary
 (MarektCap – (NOPAT/WACC)) / MarketCap where
 Generally speaking . . .
 For further information on this topic, see . . .
 Robert J. Shiller, Stock Prices and Social Dynamics, 1984 Brookings Institution Paper
 Charles M.C. Lee, Market Efficiency and Accounting Research, 31 Journal of Accounting and Economics, 23353 (2001)
 Fischer Black, Noise, Papers and Proceedings of the FortyFourth Annual Meeting of the America Finance Association, New York, New York, December 2030, 1985, Journal of Finance, Vol. 41, Issue 3 (July 1986)