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What does the Absolute PE Model mean?
Fundamental analysis exists in a dynamic environment. In order to increase the precision of the analytical process, new formulas, methods, strategies, tools, and technologies are frequently presented around the world.
However, while most of these new debuts last for a while before being replaced by something new, a select few strategies have managed to hold onto their position. Absolute PE is one such well-liked stock analysis technique.
Absolute PE Model by Vitaliy Katsenelson
In his book Active Value Investing, published in 2007, Vitaliy Katzenelson first introduced the absolute PE (Price-to-Earnings) model. Since then, investors have compared and fundamentally analyzed other companies using this methodology.
Based on the company’s dividend yield, earnings growth rate, financial risk, business risk, and earnings visibility, it calculates the intrinsic value of the stocks. The formula used to determine a company’s intrinsic value is given below.
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How to Calculate Absolute PE?
There are six steps involved in calculating absolute PE, which are broken down into two groups:
- Adjusted PE
- Risk Multipliers
Here, you must first understand the business before calculating the degree of risk involved. It’s difficult to determine the level of business risk and either give it a premium value or a discount. However, this model contains guidelines that make it feasible and desirable.
Adjusted PE includes the following;
Base PE
The price-earnings ratio sometimes referred to as the P/E ratio, P/E, or PER, measures how much a company charges for its shares compared to how much it earns per share. The ratio is used to figure out whether a business is overvalued or undervalued.
And, Base PE is when we know there’s no growth in the company’s earnings. So, we value a company’s share price by its current market price to its current earnings per share. Consider this as your 1st-year earnings. So, there’s no growth involved.
EPS Growth
Each year, every quarter, the company comes up with its financial statement and earnings figures. We see the growth rate of Earnings per share over the period, we see the trend of growth and quantum and the pace of increase.
Aggressive growth in earnings could make the PE ratio seem attractive and vice versa. Since the denominator of the PE ratio is Earnings, we must know the growth rate number in order to find the adjusted PE.
Dividend Yield
The dividend per share divided by the share price equals the dividend yield, also known as the dividend-price ratio of a share. It is also the total annual dividend payments made by a firm divided by its market capitalization. It’s frequently stated as a percentage.
Since the dividend is the earnings distributed to shareholders, we need to know the growth in dividend earnings in the hands of shareholders to estimate the absolute PE of a company.
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Risk Multipliers include the following;
Business Risk
Business risks are the chances that a company will have insufficient profits as a result of unpredictabilities such as shifts in consumer preferences, strikes, increasing competition, shifts in governmental regulations, obsolescence, etc.
Business risk can be both due to internal and external factors in an economy. Business risks affect the company’s Revenue, and Gross & net profit.
Financial Risk
The risk that firms take relating to their financial transactions is known as financial risk. It is the company’s own credit risk with suppliers, vendors, and various stakeholders. When a company offers its clients financing for goods, it assumes a financial risk because there is a chance that the customer could stop making payments.
A business must manage its own credit responsibilities by making sure it always has enough cash flow to make timely payments on its accounts payable bills. If this doesn’t happen, suppliers may either cease giving the company credit or perhaps stop working with the company altogether.
Earnings Visibility Risk
Earnings Visibility is seeing for those factors that could dampen the company’s earnings capability. It is to see if there’s any reason for the company to earn less in the coming quarters. And, if so, what is the impact?
If we are unable to predict the future earnings of the company be it due to the organization being a cyclical one or of unique business models, the said company would be termed a risky venture.
Principles of Absolute PE Model:
It’s critical to comprehend the big picture for each condition, as this model is based on how the 6 criteria listed above function.
You’ll find it much simpler to use this absolute valuation approach if you take a step back and consider the larger picture rather than just trying to figure out the formula and get to work.
The 5 Core Principles of Absolute PE Model:
- Base PE is considered with no potential growth in Earnings.
- Understand the Impact of Earnings Growth on the PE ratio.
- Consider Dividend Yield (if paid by the company) in your Valuation metrics.
- Business Risk is not certain. Infact, nobody can estimate the exact impact on business due to its external forces.
- Financial & Earnings Risk is estimated based on the analyst’s calculation. No certainty over what the figures could be.
Absolute & relative P/E ratio
Absolute P/E is simply the price of a stock divided by the company’s earnings per share (EPS). This metric shows how much money investors are willing to part with for every rupee of profit. The relative P/E ratio, on the other hand, is a metric that contrasts the present P/E ratio with the company’s or a benchmark’s previous P/E ratios.
How to Estimate Stocks Via Absolute PE Model?
Finding the Adjusted PE—a base PE that has been modified for EPSG and DY—is the first step in calculating Absolute PE. The following formula can be used to compute Absolute PE after you have the base PE:
Absolute PE = Adjusted PE (X) Risk Multiplier [BR x FR x EVR]
The absolute PE ratio’s denominator can be either the trailing EPS (from the trailing 12 months [TTM]), the estimated EPS for the next 12 months (forward P/E), or a combination of the trailing EPS of the last two quarters and the forward P/E for the next two quarters.
Typically, the numerator of this ratio is the current stock price. For instance, the P/E is 20 (Rs.100 / Rs.2 per share earnings) if the company is now trading for Rs.100 and the TTM earnings are Rs.2 per share.
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Conclusion:
You can utilize a strategy that employs stock multiples in a much more isolated way by applying the absolute PE method. You don’t have to just focus on competing multiples and try to change your stock to meet their requirements. Instead, you can use it in a more general way.
It’s simple to start entering data into a spreadsheet and taking the data at face value. But what you really need is a variety of valuation models from which you can choose the one that applies to that stock.
Although the model is subjective and the quality of the outputs depends on the quality of the inputs, the method is simple to understand and put into practice.
Disclaimer: All the information on this website is published in good faith and for general information purposes only.
