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Status: In Progress  |  Genre: Personal Finance  |  House: Booksie Classic expository guide on how to unlock and gauge the future value of an asset/company from a risk-discounted perspective, by weighing in on the likely sentiment of investors/market participants.

Submitted: June 06, 2019

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Submitted: June 06, 2019



I have noticed that most investors like to use the PE(price earnings) ratio as a key determinant with valuing a company. While its not a bad idea, a much better valuation tool to use would be the price earnings growth(PEG) ratio, which compares the price earning(PE) of the asset in question to its actual growth in earnings. ...but even then, there is a danger with using either tool in isolation.

Like I always tell folks; the best way to gauge the inherent value or driven potential of an asset or company is by taking several key fundamental variants as a collective, and weighing it against the surrounding economic risk at the time.
By the way, the price earnings multiple(PE for short) is simply a financial terminology that describes how the share price of a stock relates to its earnings per share(EPS)
Mathematically, PE = P/EPS. ...where P is the equity price.
As can be seen from the equation, the PE weighs the extent or how much investors are willing to pay(price) in multiples of the current derived earnings(EPS) of a given company.
Again, because the PE is directly and inversely proportional to the price(P) and EPS in that order, an investor might sometimes misconstrue that a high PE(which by variation derives from a high price and a low eps) shows that a stock price is overvalued and vise versa. ...but this is not usually the case.
That is an ineffective way to use a company's PE to guage value.
So while it might be ok to use PE or better still, the PEG ratio as a valuation tool, they're best utilized when viewed relatively to draw a better inference with any given company.
...otherwise a high or low PE/PEG ratio would only count for little or nothing.
The most efficient way to use the price earnings multiple(PE or PEG) is to BENCHMARK and RELATE it to the possible RISK PREMIUM associated with a given asset/company to see if indeed such risk has been minimized(from an economic context) to a level that can drive market sentiment within a specified period.
...because it is that sentiment(either positive or negative) that would eventually reflect in its share price.

Let's break it down;

In principle, as the risk premium associated with a given company decreases, an increase in derived earnings(EPS) would almost always eventually translate to a higher increase in price irrespective of whether the PE was high or low.
Once u can understand this, u would know that the key to look out for, if u truly wish to reap from the underpriced/undervalued stance of an equity is in the clause; LEVEL OF RISK PREMIUM and not necessarily the PE.
Because the weighting of an asset or company's risk premium is what determines the gap/MoS(margin of safety) that an investor can 'tap from', and that 'gap' preceeds VALUE... while the value eventually drives PRICE !!
This explains why the price of a stock with high risk premium surrounding it may stay low and remain relatively low for long, even with a low PE.
Similarly, its also why the price of another security with low risk premium may stay high and remain relatively high for a while, even with a high PE(e.g. nestle nig plc)
The KEY is to focus more on the parts in italics above and not just PE.
Here's a practical example;

The last spate of financial print shows that FLOURMILLS PLC(a company, quoted on the floor of the Nigerian stock exchange) has had to struggle with growing their earnings margin, having had bumpy periods.
Expectedly so, given that the high stiff competition coupled with an influx of smuggled lower price alternatives(including sugar), debt concerns worsened by a high interest rate environment, logistic challenges, lower purchasing power driven by a hightened economic downturn and uncertainties surrounding the fx market space had between 2017 to mid 2018 all but aided the high risk associated with the company. ...risk premium was high !!
Let's assume that the stock was selling for N30 at the time.
Assuming they erked out an EPS of N3, PE will be = 10 this SCENERIO 1.

Now assuming the government bans the import of some of the company's target goods or discourages smuggling by increasing import tariff, while its managers puts a good mechanism in place to improve logistics, better manage its debt burden by paying down short term accruals, cutting off on funding mismatches and/or having a better loan interest payable and there is a reducing interest rate environment and a more stable fx space... then u'd expect that associated risk at this time would've indeed trickled down.
Let's assume that this time, the stock now sells for 1/2 the price in scenerio 1.(N15)
Also, assuming the coy returned an EPS of N1.2, PE will now be = 12.5 this SCENERIO 2.

Note how the PE in scenerio 2 is higher than that in 1.
Yes the company's equity price and attributable earnings(EPS) may have been more in scenerio 1 than 2(because of the drawback with risk in scenario 1), but a lower risk premium(better state of health) in scenerio 2 means that there is an MoS gap to tap from, so it's PRICE(N15) has got to drive up to catch up with its VALUE irrespective of the higher PE.
So always focus more on the sourrounding 'risk curve', which would invariably impact on the 'heartbeat' of a company's equity.
Because a lower risk means an improved health from a better 'heartbeat', which would eventually drive the needed positive sentiment.

That's basically one sure way that sentiment drives the circle of demand and supply and impacts the price of an asset.

This is an effective guide to spotting true VALUE if one can efficiently follow it through and through.
Similar partterns can also be used to spot great value and growth stocks/asset at any given point in time.
At the moment, stocks like MAY & BAKER, CAVERTON, CUSTODIAN, AIICO, FCMB, FIDELITY, ZENITH, UBA, ACCESS, WEMA, GTB and LEARNAFRCA(all quoted on the NSE) to mention just a few readily comes to mind.
...with their associated risk premium peculiar to each of them and the market sector they belong to.
Comparisons can also be drawn from different securities with the same or similar sectors to better gauge the level of possible MoS with inherent value.

Bottom line: every asset class of investment has a measure of risk, but your rate of success will depend on how well u can relate the risk premium associated with it to the inherent value therein.
It's a great way to better your asset yield or grow your ROI 'the sentimental way'.

May that be your lot !!

NOTE: While the PE multiple method can be a simple handy guide to value investing, its imperative to state that its use is best when supplemented with other key valuation driven methods, to achieve optimum result.
...which is why this series will likely have other parts to it.

Watch this space !!

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