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Yesterday RealMoney.com published a column I wrote about the Earnings Power PIV-ER test, which I devised last Fall. I can't reproduce the column verbatim here, so I have deleted the actionable ideas. Please do not ask me which companies they are, as this is unfair to paying subscribers. Besides, I think the tool is more valuable in the long run than the companies to buy and sell today.

If you use the PIV-ER test, I believe it will help you stay on top of all the promising stock ideas you read about in a disciplined manner. In addition, PIV-ER can improve your portfolio management performance, a vital but little-discussed topic on the sites I visit!

PIV stands for price-intrinsic value and ER for expected return. PIV is a measure of downside risk, and ER gives a sense of upside potential. The lower a stock's PIV and higher its ER, the better.

You need four pieces of data to build a PIV-ER test. To illustrate, let's use Wal-Mart (WMT). I took these numbers from Yahoo! Finance earlier this week.

· Current stock price: $48
· Earnings per share (trailing 12 months): $2.62
· Book value per share: $14
· Annualized growth, five years: 13.0%

Using these numbers we construct three scenarios--High, Medium, and Low.

The High scenario has Wal-Mart's earnings growing at the consensus estimate, 13%, for the next five years. Because analyst estimates are unreliable (more below), the Medium and Low rates are 75% and 50%, respectively, of the High.

Beginning in year six, I assume annual growth is one-half of the forecasts for years one through five. The reason I assume growth will slow is because of the law of regression to the mean. So High growth slows to 6.5% a year, while Low and Medium are 3.3% and 4.9%, respectively.

Terminal growth, which begins in year 11, equals inflation, which I assume is 3%.

Estimates for intrinsic value to common equity range from $62 to $84 a share. If we assume the chances of the Low, Medium and High scenarios occurring are 40%, 35% and 25%, respectively, then intrinsic value is $71 -- i.e., $25 + $25 + $21.

If Wal-Mart's stock price is $48 and its intrinsic value is $71, then its price-intrinsic value (PIV) is 67%. This means we can buy a dollar's worth of value (part current net worth, part future earnings) for 67 cents. When you buy a company for less than true worth, you give yourself a margin of safety to protect yourself against what Ben Graham famously called "miscalculation or bad luck." The lower the PIV, the bigger your margin of safety -- provided, of course, that your intrinsic value estimate is solid.

Now, upside potential. Wal-Mart's expected return (ER) is 48%, which I calculate by subtracting the stock price from intrinsic value and dividing that result by the stock price -- i.e., ($71-$48)/$48. Expected return tells us how much profit we can expect, in percentage terms, if we buy Wal-Mart at the current price and then the market immediately bids it to fair value. The bigger the expected return, the better.

As mentioned, PIV-ER is conservative. Two of the three scenarios used in the test are based on growth rates below analysts' consensus, growth in all three scenarios is modeled to fall 50% in year six, terminal growth begins just 11 years from now, and 75% of intrinsic value is based on the Low and Medium scenarios.

I built these safeguards into PIV-ER because analysts' earnings forecasts are unreliable. In Contrarian Investment Strategies, legendary contrarian investor David Dreman found that the average error was 44% annually (!!!), based on a study of 500,000 quarterly estimates of more than 1,500 companies from 1973 to 1996. Given this deficient track record, a hopeful but cautious pro forma is the best policy.

Now that you can build a PIV-ER, here's how to use it to improve your productivity: Run every company in your portfolio through this test and then put their PIV and ER results into a spreadsheet. Then calculate your portfolio's PIV and ER. Assess every new investing idea's PIV and ER, and compare them to your portfolio average.

My portfolio's weighted average PIV and ER are 52% and 128%, respectively (fluid numbers, to be sure). This means that on average, my stocks sell for just more than half their intrinsic value, and my potential upside is north of a double. I like this risk-reward mix. Of course, my growth forecasts may be wrong.

Again, as you get new ideas, log the PIV and ER results in a spreadsheet and then compare them to the values for what you already own. You want to methodically nip-and-tuck to get the best risk/return combination. While I recognize Wal-Mart's earnings quality and competitive advantage, the stock has to fall to the low $40s before it will strengthen my portfolio. If a company does not have a lower PIV than 52% and a higher ER than 128%, then it is illogical for me to buy it.

PIV-ER saves time. But as with any quantitative model, PIV-ER is only as good as the numbers that go into it. So use it as a preliminary screen. Then, after using the Earnings Power Chart (www.earningspower.com) to gauge the quality of GAAP profits and assessing a firm's competitive advantage, use PIV-ER a second time. Once you know the company better, you might want to use free cash flow instead of GAAP earnings, or perhaps adjust the growth rate assumptions. It's your choice.

Also inspect book value carefully. Assets may include intangibles that don't add revenue or cut costs, forcing management to write them off at some point. On the liability side, operating leases, unfunded pension plans, employee stock option liabilities and environmental hazards can also overstate corporate net worth. The company may also have hidden assets, which give net worth a boost.

If I update It's Earnings That Count (McGraw-Hill, 2004), I intend to devote a chapter to the Earnings Power PIV-ER test. I look forward to using PIV-ER to optimize my portfolio in 2007, and to also determine which companies belong on my “on-deck circle.”

I am also posting this on the Hidden Gems and Inside Value discussion boards, and will be happy to answer questions.

Hewitt
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