Valuation Model using Historical 10Y PE | Alpha Quadrant by The Fifth Person

Questions › Category: Financials Quadrant › Valuation Model using Historical 10Y PE

SG_Daniel asked 3 years ago

Victor, I have noticed you have used the past 10 years PE when you apply the valuation model. What is the reason for choosing 10 years and not like 15 years or most recent 5 years? I wonder is there any specific reason for choosing 10 years as the selection actually will determine if the current stock price is fairly valued, under-valued or over-valued?

4 Answers

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Victor Chng Staff answered 3 years ago

Hi Daniel, Analysing the historical PE allows us to observe how investors have reacted during various periods, including times of crisis. If the timeframe is too distant, it may not accurately represent current investor sentiment, as perceptions can change over time. On the other hand, if the timeframe is too recent, it might reflect excessively high optimism. I think that ten years reflect a much more reliable gauge of average market sentiment.

SG_Daniel replied 3 years ago

Noted.

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SG_Daniel answered 3 years ago

Hi Victor, Let's say a stock has a financial year ending 31st Dec, and it reports earnings around end Apr, Jul, Oct and full year results around end Feb. When constructing the 10Y valuation chart (2013 to 2022), the share price is downloaded from Yahoo finance. Since Annual Report is out by end Feb, the earnings column will be filled up as follows:

01.03.2013 to 28.02.2014: Using 2012 EPS
01.03.2014 to 28.02.2015: Using 2013 EPS
and so on, till ...
01.03.2023 to 28.02.2024: Using 2022 EPS?

Q1: If above method is correct, then the intrinsic value will be fixed throughout the period 01.03.2023 to 28.02.2024. Is this correct? Q2: Since 1Q and 2Q (or 1H'23) results are out now, I wonder if we have to use EPS from 2H'22 and 1H'23 for the valuation table. Should we consider using TTM EPS? Q3: However, if the answer to Q2 is a 'Yes', then do we need to use the TTM EPS when we construct the valuation chart (which means Q1 is incorrect). So maybe we should not consider using TTM EPS when constructing the valuation chart, is it correct? I'm asking the above questions is because if the intrinsic value is fixed as depicted in Q1, then is there something one has to consider when evaluating whether the stock is over, under or at value since there are new EPS information released by the company. However, the construction of the valuation chart will become more complicated if we were to keep using TTM EPS. If the latest year has to consider using TTM EPS, then shouldn't the other 9 years also use TTM EPS. Since you have mentioned valuation is both a Science and Art, is it correct to say we will use the yearly results' EPS for the valuation chart and table to derive the intrinsic value?

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Victor Chng Staff answered 3 years ago

Hi Daniel, Your timeframe is correct. The intrinsic value is not fixed because when the new EPS is released, you will take the trailing twelve months (TTM) EPS and multiply it by the average. The key is to be consistent with your valuation method; you can use either a historical PE chart or a TTM PE chart, as long as you maintain consistency. Based on my experience, historical PE charts and TTM PE charts are often within a +/- 5 range most of the time.

Feel free to ask more questions if you don't understand.

SG_Daniel replied 3 years ago

Victor,

Just to confirm both these methods are what you are saying.

Method 1: Plot the historical 10Y PE chart (01.01.2013 to 31.12.2022) using data from Yahoo Finance and calculate the average PE ratio (let's says it's 5.97). Once new EPS is released, calculate the TTM EPS and multiply it with the average PE ratio of 5.97 to get the intrinsic value.

Method 2: Plot the historical 10Y PE chart similar to method 1 first. When new EPS is released (let's say it's released on 30.04.2023 which is today), then we will use this new EPS to calculate the TTM EPS from 3Q 2022 to 1Q 2023 to get the intrinsic value.

I have the following questions to clarify.

Q1: For Method 1, we are using historical 10Y average PE ratio (5.97) for period 01.01.2013 to 31.12.2022. But TTM EPS will be after 31.12.2022. Is this way of calculating the intrinsic value is correct (using average PE ratio of 5.97 for period 01.01.2013 to 31.12.2022 but using TTM EPS for period 3Q 2022 to 1Q 2023)?

Q2: For Method 2, if we need to consider TTM EPS for the PE chart, do we need to move the 10 years' period forward? For example, today is 31.05.2023, do we need to shift the START DATE of the past 10 years of PE data from 01.01.2013 to 01.06.2013 so that the whole series of data will be 10 years till 31.05.2023 (of course with TTM EPS updated on 01.05.2023 to 31.05.2023)? Then we calculate the new 10Y average PE ratio (for period 01.06.2013 to 31.05.2023) using TTM EPS (let's says it's 4.09). Then we use 4.09 to multiply the TTM EPS to get the intrinsic value. So the question is do we need to shift the START DATE to calculate the average 10Y PE or still use the START DATE as being 01.01.2013 but add more data points going forward (which means more than 10 years) to plot the PE chart and calculate the average 10Y+ ratio?

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Victor Chng Staff answered 3 years ago

Hi Daniel, Method 1 is correct. As for Method 2, when the latest quarterly EPS is released, the share price moving forward should be using TTM EPS to plot the chart. When you calculate TTM EPS, it should be the latest 12 months. So the period should be 2Q2022 to 1Q2023.

Q1: When calculating intrinsic value, there is no absolute correct answer. What we are doing is to see how the company is trading based on historical averages. To buffer any miscalculation, that is also the reason why you need to have a margin of safety. The method that we teach so far still works well for us. Q2: When plotting a TTM PE chart, you should have a new EPS figure every quarter when plotting a 10-year PE chart. The method is very tedious if you will to plot it. That is the reason why we recommend using method 1 which is much simpler. Alternatively, if you want a TTM PE chart, there are paid services that do it for you such as Kyofin, Ycharts and TIKR.

SG_Daniel replied 3 years ago

Victor, thanks for the clarification.