We often try to judge whether a stock price is over or undervalued using PER alone. However, it could make an error when, without the fundamental factors, evaluating the price only with PER. Suppose that there are two companies, A and B, which have a similar business, have a PER of 10 and 20, respectively. When considering PER alone, we could decide that B’s share price is overvalued more than A’s. However, if A’s sales and net profit have stagnated over the past five years, while B has shown 30% in them for the same period, the first judge may be wrong. Therefore, it will help if you evaluate PER with fundamental factors.
Intrinsic PER using fundamental determinants
You can calculate PER using the price from the stock market. However, you can also get the theoretical or intrinsic PER with the fundamental figures from financial statements. We will use DDM (Dividend Discount Model) to illustrate the determinants of intrinsic PER.
For companies that grow stably
In the DDM, you divide the next year’s dividend by the difference between the discount rate and the growth rate to get the stock value. Here, the assumptions are that the dividends grow at a constant rate, and the cost of equity should be greater than the growth rate. Thus, this model is suitable for the companies with such attributes.
When you divide both sides of the above equation by the previous year’s EPS, you can get Current PER.
The ratio of paying dividends from net profit is the dividend payout ratio so that ‘Dividend1 / EPS0‘ becomes ‘Payout Ratio x (1+gn)’. You get Forward PER by dividing both sides by the following year’s EPS instead of the previous one.
From the above formula, you can see that the determinants that make up the intrinsic PER comprise payout ratio, discount rate, and growth rate. The intrinsic PER increases as the payout ratio or the growth rate increases or the risk decreases.
For high-growth companies
You can use the second-stage DDM for a company that grows rapidly during a temporary period. The formula is as follows.
When you divide both sides of the above equation by the previous year’s EPS, the formula for the current PER is derived.
Valuing Dyson’s share with intrinsic PER
You can calculate the intrinsic PER of Dyson, the case from the former blog, with the fundamental elements. It is beneficial to compare the intrinsic PER to the market PER and analyse both results. In the case of Dyson, net income has grown 250% over the past five years, and dividends too. Thus, if you didn’t use the PER of the comparable companies with such a high growth rate, the fair value of Dyson’s stock may be not proper.
Since Dyson is a high-growth company, we will try to apply the second formula above. We can calculate the intrinsic PER of a high-growth company through four steps.
- First, you need to estimate a future growth rate. To get it, you might have to look into the recent trends of the company, interview the insiders, and research on the industry. However, we will use a simple method that refers only to the trend of past growth rates here. Dyson’s dividend payment has soared as its net income has increased significantly over the past five years. However, the growth rate over the last three years has slowed to 326%, 96%, and 50% in order. In line with that trend, let’s assume the growth rate of 20% during the high growth period and 4% during the stable period.
- Second, you should set up a period of high growth. That will be the next two years for Dyson. The scenario is that it grows at 30% for the first year and 10% for the second year (average 20% for two years) in line with the past growth rate trend. Then, Dyson grows at 4% during the stable period.
- Third, you predict a payout ratio. That was very high for Dyson. In 2016 and 2017, it was over 100% by paying even the previous year’s retained earnings as dividends, and in 2018, it was 94%. Thus, we will assume that Dyson would pay 90% of net income as dividends for both periods.
- Finally, you need to get the cost for equity capital. As of August 2020, the UK Gilt yield is 0.19%, and the market premium is 7.47%. The average β of the ten comparable companies is 0.86. Upon CAPM, the rate is 6.59%, which will be applied to both periods.
re,Dyson = 0.19% + 0.86 x 7.47% = 6.59%
Substituting the fundamental figures above into the formula is as follows.
Dyson’s intrinsic PER is about 46. Applying that multiple, Dyson’s estimated share price is £5.4million, and the total stock value is approximately £12billion. You can see the sensitivity of the PER by changing the period of high growth, the payout ratio, the growth rate, and the cost of equity capital in the yellow cells of the Excel above.
In the case of a second-stage high-growth company, intrinsic PER increases as the period of high growth is longer, the payout ratio is higher, the growth rate is higher, and the cost of equity capital (risk) is lower.
In the previous blog, the trailing PER from the comparable companies was 29, much lower than Dyson’s intrinsic PER. In fact, Dyson’s growth rate and dividend payout ratio are much higher. Therefore, it seems more convincing to apply the intrinsic PER of 46 than the market PER of 29.
- (Excel Financial Model) Valuation of Dyson’s stock, a private company, using PER
- (Blog) PER and Valuation of a Private Company – Case of Dyson