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Mathimatix (and others),

PEG is in fact a rule of thumb, but a rather weak rule. The PE Calculator is more than a rule of thumb; it is a quick tool to approximate the fair value of a common stock. The key word is "approximate" since, in my opinion, any stock valuation model is an approximation, at best. The long spreadsheets and earnings models used by professional analysts are more precise but not necessarily more accurate. The usefuleness of valuation models is to find a "margin of safety" (per Ben Graham, Warren Buffett). Look for investments well below their approximated fair value.
A couple of other caveats:

Garbage in, garbage out. You can make a stock worth anything you want if you stretch earning forecasts to the extreme.

Use a logical EPS in your P/E. This has become more difficult with goodwill amortization, write-offs of R&D, nonrecurring income from sales of investments, etc. This may take some digging, usually by reading 10K and 10Q reports.

Anyhow here is a text file I wrote, explaining the background and rationale behind the PE Calculator (the actual calculator is a spreadsheet, so I do not know how to make it readily available. Suggestions are welcome.)

The PE Calculator

How much is a share of common stock worth? Is the answer simply, "whatever someone else will pay for it?"

That is the question I found myself asking in early 1996. The S&P 500 had had a great year in 1995. My portfolio stunk. I looked back over all of my trade confirmations for the year. It seemed that I was always buying and selling at the wrong time: buying something hot just before it topped out or selling a truly great stock because it pulled back more than I could stand. What was I missing? Let's see... I was missing one little piece of information: I HAD NO IDEA WHAT ANY OF MY STOCKS WERE REALLY WORTH.

So I decided that I was going to find out if stocks really do have an "intrinsic value." The alternative was distressing -- that the financial markets are just a giant auction of collectibles. If stocks do have an intrinsic value, then when my stocks go down I would not need to panic. I might even buy more because I would know that my investments actually have an economic value, like a bond or cash but with different risk and predictability parameters. I might even see some long-term value in temporarily troubled companies. As an individual investor I do have one edge over some of the pros: I can define "long term" as longer than "12 to 18 months."

Having spent most of my life in school (I am a physician), I turned to books. I found myself at the public library, and my first withdrawal was The Portable MBA in Finance. I finally understood what Robert Sanborn (of the Oakmark Fund until recently) meant when he said "the present value of future free cash flow." I also read Hagstrom's The Warren Buffett Way and Roger Lowenstein's Buffett biography. I was ecstatic. An investor reborn. I started investing with my new found principles that spring. At first I used dividends in my valuation model. I bought some boring "old economy" stocks which have done fairly well (Clorox, Pitney Bowes, Wachovia). Soon I modified the model to use free cash flow. I started and still maintain a spreadsheet to follow the trailing twelve months of free cash flow for all of the stocks I own. Eventually, this led to some disappointment.

How the PE Calculator was born:
As I followed my stocks and their quarterly TTM free cash flows, one thing became obvious. Free cash flows moved in an even more nonlinear fashion than earnings. To some, this is the advantage of looking at cash flows rather than earnings. The legal but slippery accounting maneuvers used to smooth earnings are taken away. Free cash flow also takes into account capital spending, and this expenditure is nonlinear by its nature. Big projects are not done every year, but perhaps every few or several years. Still, I was valuing my stocks on numbers which seemed to vary quite a bit from quarter to quarter. I knew I did not want to find a great buy one quarter, only to find the free cash upon which I had valued it had disappeared in the next quarter. After about two years of investing serenity, I was starting to doubt my cherished, and mostly successful, methods. Despite some pride in what I had learned and accomplished, I knew that over two years I could have been just plain lucky. (I still think this after four years.) Another troubling realization was that fast growing companies often have little or no free cash flow. They need to reinvest their cash to continue to grow. They might be valuable for the cash they generate in the future, perhaps five or even ten years in the future. After all, discounted free cash flow models value companies on all of their future cash, even if its not here this year or next. My valuation technique had no provision for recognizing the value in these faster growing businesses. I had to rethink what I was truly looking for.

What the PE Calculator is and how it works:
The PE Calculator is simply a small spreadsheet which calculates the fair PE ratio for a stock. Inputs are the 30-year Treasury Bond rate, an equity risk premium, the number of years of faster stage one (or one and two) growth, fast growth rate(s), return on equity, and constant slow growth rate. It is based on a two or three-stage discounted free cash flow model. What makes it different is that it is also based on a less glamorous formula found in finance texts:

PE=(payout ratio)*(next year's earnings)
discount rate - constant growth rate

The payout ratio usually means the portion of the earnings which are used to pay cash dividends. Instead, I use a hypothetical free-cash-flow payout ratio which comes from inverting another concept -- sustainable growth. Many years ago I had come across sustainable growth in an article in the Journal of the American Association of Individual Investors. It was defined as:

Sustainable growth=Return on Equity*(1- payout ratio)

This formula can be manipulated to: Payout ratio= 1- (growth/ROE)

When growth is less than return on equity, there is extra cash which is "free" to pay a cash dividend, buy back stock, pay down debt, or acquire another company. When growth is higher than ROE, it will decrease the economic value of the business during those years (more capital will need to be raised through debt or dilutive equity), but higher future earnings can add great value when growth slows in the future. It is funny to think that today's hottest, fastest growing technology companies may only attain real economic value when their growth slows. I doubt many of their most bullish investors will be willing to wait that long.

Steven Zekowski
April 4, 2000
St. Paul, Minnesota

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