hi, i had a thought about valuations and how to be a bit more specific. Valuations have always been a point of debate. How much P/E, P/BV etc? DCF is very tricky. Forecasting cash flow over next 20 years is a mechanical exercise.

What I am experimenting with is as below:

1. Take current EPS/FCFPS and derive earnings yield (E/P or inverse of P/E). FCFPS = Free Cash Flow per Share
2. Compare that with alternative yield that can be earned e.g. FD at 9.5% or some other investments as an option. Its preferable to take post tax at highest marginal tax rate=9.5%*(1-30.3%)=6.62% since that is what an investor will get in hand.
3. Take the next 3 years’ EPS/FCFPS (before raising debt—else company can keep raising debt in excess of needs)
4. The reason that current earnings yield in most cases will be lower than 6.62% (= 100/6.62=~15 p/e) is that there is a growth component in earnings. So if a company is valued at 18 p/e, earnings yield is 5.55% (1/18%). Therefore if somebody invests in FD at 6.62%, then that is the rate the earnings yield must reach in 3 years time. Any growth in earnings after that is a bonus.
5. So at 5.55% yield or 18x P/E, earnings yield needs to grow at 6% pa to reach 6.62% in 3 years time (5.55%x1.06x1.06x1.06=6.6%)
6. If EPS/FCFPS is growing at a rate higher than 6%. For instance at 10%, then we can discount back 3 years to find out the growth rate that earnings yield or earning must be such that if they grow at 10%, the earnings or yield will be 6.62% in 3 years’ time. Therefore 6.62/(1+10%)^3)=4.97% or a P/E of ~20x (1/4.97%).
7. So we are effectively paying a higher P/E for growth
8. Once we have a target price, it will give us an upside from CMP and we can then build in a margin of safety since the price is a target for achieving the expected growth rate.
9. We can combine this with other metrics like P/B, DCF to see how different the values are and if required take a weighted average etc. It then becomes a subjective preference. Additionally, if on analysis we find that for instance RoE is lower than a threshold of ~20% then we can increase the asking rate or the target yield by 50 bps or 100 bps. Similarly, if its RoE/RoCE, working capital is exceptional, then we can lower the asking rate by 50 bps etc.
10. This is not without its contradictions though. For instance at a P/E of 20x in above example, PEG is 2x for a growth rate of 10% when ideally it should be 1x.

Pls let me know about your feedback on the same. I am sure there must be some thing I may be missing but haven’t got around to it yet.