I am rebuilding a spreadsheet that I use to value equities and am working on the calculation of the Intrinsic P\/E, so to help give myself a refresher I am writing it all out for the benefit of my readers, so enjoy!<\/p>\n
The intrinsic p\/e is the sum of the tangible p\/e and the franchise p\/e. The tangible p\/e assumes the company has no growth or that it will pay out all of its earnings. The franchise p\/e represents the present value\u00a0of future growth and is broken down into two components, the franchise factor and the growth factor.<\/p>\n
I will use an example as shown on page 192 of the 2010 CFA Program Curriculum, Level II, Volume 4.<\/p>\n
In the example, the company can generate a return on equity of 15% (ROE)\u00a0and the earnings retention ratio is 0.60% (b). Earnings next year will be $100 million and the required rate of return is 12% (r).<\/p>\n
First, let’s calculate the tangible p\/e. The tangible p\/e is simply 1 divided by the required return. In this case, that is 1\/.12=8.33.<\/p>\n
Next, we calculate the two components that make up the franchise p\/e.\u00a0 The two components of the franchise p\/e are the franchise factor and the growth factor\u00a0and the franchise p\/e is the product of those two numbers.<\/p>\n
The franchise factor would be the first component and it “is meant to capture the return levels associated with” new investments. The formula is:<\/p>\n
(1\/r) – (1\/ROE) = (1\/.12)-(1\/.15) = 1.66667<\/p>\n
The second component is the growth factor. “The growth factor captures the present value opportunities for productive new investments.” The formula is:<\/p>\n
(b * ROE)\u00a0\/ (r-(b*ROE)) =\u00a0(.6 * .15) \/ [.12 – (.6*.15)]\u00a0 = 3<\/p>\n
The retention rate (b) multiplied by the ROE is the growth rate (g), so we can simplify the formula as follows:<\/p>\n
g = b * ROE = .6 * .15 = .09<\/p>\n
and then the growth factor formula is now:<\/p>\n
g \/ (r-g) = .09 \/ (.12 – .09) = 3<\/p>\n
Now, let’s calculate the franchise p\/e:<\/p>\n
Franchise PE = Franchise Factor x Growth Factor = 1.6667 * 3 = 5.00<\/p>\n
The intrinsic p\/e is equal to the sum of the tangible p\/e and the franchise p\/e.<\/p>\n
Intrinsic p\/e = 8.33 + 5.00 = 13.33.<\/p>\n
If the company earned $100,000,000 the intrinsic value would be 13.33*$100,000,000 or $1,333,000,000. There are additional formulas that take into account inflation but I am not covering that here.<\/p>\n
There you have it! Everything you wanted to know about the calculation of the intrinsic p\/e.<\/p>\n
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I am rebuilding a spreadsheet that I use to value equities and am working on the calculation of the Intrinsic P\/E, so to help give myself a refresher I am writing it all out for the benefit of my readers, … Continue reading