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Linking Future Value with Current Value

By Kevin GilloglyHDIC Education Segment

March 14, 2005

Part I

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They Invest in Companies They Don’t Understand

They Don’t Know How to Value a Stock

They Pay Too Much

Reasons Most People Fail in the Stock Market

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Linking Current Value & Future Value

Current Value is _______? Future Value is based on ________? Knowing these two terms is a simple,

yet effective way, to protect yourself from overpaying for a stock

Value of Classic’s Stock Wizard Use red alerts to guide you

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Stock Valuation

Is a method of directly connecting the stock price to the company’s profits (EPS), and is expressed as a ratio of price to EPS.

P/E Ratio = Stock Price / EPS Wall Street’s way of measuring the

value of the growth of the company

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Price Follows EarningsWAG

The price need not grow at the same rate as the earnings. When EPS advances the

price will almost always advance.

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Section 3 for Walgreens

EPS growth has been around 17%.Which of the high P/E’s are reasonable?Which of the low P/E’s are reasonable?

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“Companies … with long records of above average growth tend to sell at higher P/Es, but their highs

are usually not sustainable.”

-- Handbook, 130

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Stages of GrowthFirst things first. What type of growth is this

company? Use the SSG graph to help determine (but use your judgment too) …

A fast growth company? > 20%, looks like peaks of a MT

A stalwart growth company? > 10 & < 15%, looks like foothills of MTS

A slow growth company? < 7%, looks like topographical map of DE

A cyclical company? Erratic growth, looks like the polygraph of a liar

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Stages of Growth

Break Even Point

BestInvestmentOpportunity

Speculation

Life Cycle ofA Successful

Company

No dividends

Small dividends (Payout ratio <20%)

Large dividends (Payout ratio >40%)

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Where do sales come from?Sales are the dollars that flow into the

company. It is what drives the growth of the company. It can come from:

Selling more of a product or service Making it better New uses for it Increasing demand for it

Charging more for the product or service; Increasing market share

Make it better/New uses/Increase demand Acquiring competitors

Acquire unrelated businesses

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Where do earnings come from?

Earnings is what remains after expenses and taxes. It can go to:

the owners (dividends) pay off debt (loans, bonds) be used to grow the company (equity)

Improve company operations Acquire new companies

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“Buy the rights stocks at the wrong price at the wrong time and you’ll suffer great losses.”

Peter Lynch, One Up On Wall Street, Pg. 72.

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Applying Judgment Be reasonably conservative

But not everywhere in the SSG And not all the time

Remember our goal is purchase stocks not hoard cash Be more aggressive on your future

EPS growth (Sec. 1-4) Save your conservatism for your

future P/Es (Sec. 4A and 4B) Link 1-4 with 4A

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More Stock ValuationAnother method of stock valuation:

PE/G Ratio = PE Ratio / Future EPS Growth Rate

Wall Street’s way of measuring the value of the earnings of the company

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Using the PE/G Ratio P/E ratio divided earnings growth

PE/G ratio of 1 = fairly valued; PE/G ratio of 2 = overvalued; PE/G ratio 1.5 = upper limit of fairly valued PE/G ratio under 1 = on sale

WAG has a PEG ratio of 1.75 Current P/E of 29.6 divided by historic

earnings growth of 16.9 How is WAG valued? What would be a fair future high P/E

value for WAG based on 16.9% EPS growth?

Answer: 25.4

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Linking Current Value & Future Value

Forecasting a high P/E (4A) no higher than 1.5 times (150%) of your future EPS growth on the front of the SSG (1-4) allows for the P/E to expand towards 200%.

Expanding P/Es is how to make money. Conversely, a P/E that shrinks (or

contracts) is a sure fire way to lose money.

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Using PE/G Ratio, Pt. 3

A high P/E of 46.2 / 15% future EPS growth = a PE/G ratio 3.08. To make $107.72 in 5 years time WAG would have to become severely overvalued. Is this realistic?

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Linking Current Value & Future Value

This allows us to test the reasonableness of our estimated EPS growth vs. our estimated PE ratios

Sect. 4A ties high P/Es in Sect. 3 with our future earnings growth in Sect. 1-4

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Projected P/E for WAG

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Setting Up Projected P/Es

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Projected P/E for WAG

This gives us another way to value P/Es.To learn more: Classic Manual, pg. 98

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Another Way to Determine Future Value

Add future P/Es along with future EPS growth WAG has a projected P/E of 25.6

divided by future earnings growth of 15.0 for a PEG ratio of 1.71

How does this change WAG’s valued?

Answer: No matter which metric we use WAG is overvalued using the SSG. This is not surprising for a well managed company with consistent EPS growth.

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Conclusion Look at the graph is it steady and growing? Compare EPS growth with Divided Payout

Ratio (Sec. 3-G-7) Are dividends growing faster than EPS?

That would be “pink” flag

Link future value (Sec. 1-4) with the current value (Sec. 3-9) Reasonableness (of this link) is found in Sec. 4-A

(future high PE) Limit 4-A (future high PE) to no more than 150% of 1-4

(future EPS)

Test the reasonableness of your judgments

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Questions