ESTIMATING FUTURE P/Es

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2011 Get handouts for ALL sessions at: www.betterinvesting.

1 ESTIMATING FUTURE P/Es Pat Donnelly PITTSBURGH CHAPTER DIRECTOR BETTERINVESTING VOLUNTEER ADVISORY BOARD Ken Kavula MID-MICHIGAN CHAPTER CHAIRMAN BETTERINVESTING VOLUNTEER ADVISORY BOARD March 22, 2011 Get handouts for ALL sessions at: ti t New handouts will be posted at least two days before each class session. Tip: Save this link in your web favorites. 2 1

ALL Sessions Are Recorded A follow-up email will contain links to the recordings for all of the classes in this series.

NOTE: ALL series recordings will be available to students through April 20, 2011.

2 ALL Sessions Are Recorded A follow-up will contain links to the recordings for all of the classes in this series. The will be sent to all students one day after the live presentation. NOTE: ALL series recordings will be available to students through April 20, Disclaimer: All stock references are meant to be used for educational purposes. No recommendation for purchase or sale is intended or implied. This presentation is being recorded for future use! 4 2

Learn to select a reasonable price range for the stock five years from now. 4.

3 TODAY S GOALS: 1. Gain a better understanding of estimating P/Es five years into the future. 2. Practice estimating P/Es five years into the future. 3. Learn to select a reasonable price range for the stock five years from now. 4. Gain a better understanding of potential return. 5 Remember: The Stock Selection Guide (SSG) answers two questions! The first question: Is the company a quality growth company? We learned to answer this question in previous classes. 6 3

4 Today we ll focus on the second question: Is the stock trading at a reasonable price? 7 Let s Talk About P/E? What price is used? What earnings could be used? Do you remember the abbreviation TTM? Why do we use P/Es to compare stocks? What is a reasonable P/E? What P/Es could be considered excessive? 8 4

5 How high do P/Es have to be to make you nervous? 20? 25? 30? 40? 75? Think about your P/E COMFORT ZONE! 9 Can you identify? Present Price Current P/E Ratio Average Low P/E Ratio for the Last Five Years 10 5

Do you understand how the Average P/E Ratio is calculated?

6 Do you remember how to calculate values in Columns D or E? Can you define Payout Ratio and Yield? Do you understand how the Average P/E Ratio is calculated? 11 We evaluate historical data to help us estimate a high price and a low price five years from now. REMEMBER: P/E multiplied by EPS gives you Price! 12 6

7 ANOTHER REMINDER: $4.73 comes from our judgment on the front of the SSG. 13 $4.73 $3.37 $3.37 x 1.07 x 1.07 x 1.07 x 1.07 x 1.07 = $ % 7

8 MORE REMINDERS: $3.37 represents the most recent year s EPS. Your study could be even more current and represent the most recent 4 quarters (TTM) EPS. AGAIN... Remember that P/E X EPS = PRICE! 15 Five years of P/Es are displayed on the SSG. 16 8

10 Questions to help your judgment Are there any trends? Do the averages fairly represent the numbers? Do any of the numbers stand out? 19 Remember: Look for trends Look for values that do not seem to fit We will project a HIGH P/E and a LOW P/E for the next five years. THERE ARE NO WRONG VALUES ONLY YOUR VALUES! 20 10

11 Let s pause for some questions! Average: Do you see a trend? Do any numbers stand out? What value might you choose going forward? How would you react to these judgment calls for the next five year s number?

12 33 is probably too high and 7 is probably too low. Next we will use our judgment, to choose a value somewhere in between. Lower P/Es would be more conservative. Given enough time, even a group this large could eventually agree on a consensus P/E. 23 How do you react to this list of ten P/E values arranged from oldest to most recent? Do any stick out? Is there a trend? How would you react to these judgment calls? Average:

13 P/Es in the 30s and above are rare and hard to maintain. What is your comfort zone? How is the economy doing right now? What s the average P/E for a stock right now? 25 Source:

14 Let s pause for some questions! 27 What is a reasonable High P/E for this SSG? Can we agree that 22 might be appropriate? How does this forecast compare to the current P/E? 28 14

15 What is a reasonable Low P/E for this SSG? Do you think 16 is an appropriate choice? How does this forecast compare to the current P/E? 29 Let s pause for some questions! 30 15

16 Once again: P/E times EPS = Price! We ve determined that the stock might trade as high as $ with a high P/E of An Alternative for Low EPS Selection Consider using the Last 4 Quarters EPS (TTM)

17 Adjust the Low EPS Forecast Using the most recent 4 quarters of EPS results in a slightly higher Forecast Low Price (it was 53.92). 33 Online SSG: Low Price Options NOTE: These two low price options are available in Basic User Mode. Two additional options are available in Enhanced User Mode. 17

18 The SSG gives us more than one choice for the forecasted low price. We suggest BEGINNERS stick with Choice (a). Let s check our low forecasted price of $53.92 against some historical data! 35 How reasonable is the forecasted low price based on historical data? Current price was $ week low price was $63.30 We want our low price forecast to be lower than the current price. Our forecasted low price of $53.92 is lower than the current price

19 A good rule of thumb for beginners is to keep the forecast low price at least 20% below the current price. Current price = $ % of current price = $13.82 Our low forecasted price of $53.92 follows this guideline. $69.10 $13.82 = $ If your low price forecast in (a) is too close to or exceeds the current price reconsider your projected Low P/E for the next five years

20 We have determined that in five years, PEP might trade as high as $ and as low as $ $ $91.53 Some simple calculations show us the zones. $66.46 $

21 The current price shows a HOLD. $69.10 Current Price 41 Upside Downside Ratio Price Reward Risk The Upside Downside ratio can be thought of as potential Reward vs. potential Risk

22 Pepsi We want the Upside (Reward) to be at least 3 times as large as the Downside (Risk). 43 The Compounded Annual Return based on our judgments and the current price would be 10.23%. This is on the assumption that you sell at the High P/E

23 Questions? 45 Let s practice some more with JNJ! What would you choose for a High P/E for the next five years?

24 Let s practice some more with JNJ! What would you choose for a Low P/E for the next five years? The completed SSG uses a High P/E of 16 and a Low P/E of 8. Let s do some checking: Is the current P/E between the projected high and low P/Es? Are the P/E judgments consistent with the current market and/or the current trends for the company? Are the P/E judgment choices within your comfort zone? 48 24

The completed SSG uses a forecasted low price of $35.28. Let s do some more checking: Is the forecasted low price lower than the current price?

25 The completed SSG uses a forecasted low price of $ Let s do some more checking: Is the forecasted low price lower than the current price? Is the forecasted low price at least 20% lower than the current price? Remember, each of us has our own correct answer! 49 CVS The prepared SSG used 20 and 10. Do you agree these choices are reasonable? 50 25

26 Quality Systems - QSII What value would you choose? How do you feel about the preparer s High P/E choice of 30? 51 QSII What value would you choose? Remember to pay more attention to the more recent data. Do you agree with the preparer s Low P/E choice of 15? 52 26

27 Let s follow through the rest of the QSII SSG. Remember how we calculate the $3.09 and the $ The P/E judgments and the EPS values give us a potential High Price and Low Price. Now let s divide it into Buy, Hold and Sell zones

$92.70 $75.68 Current Price: $51.60 HOLD $41.63 $24.

28 $92.70 $75.68 Current Price: $51.60 HOLD $41.63 $ Evaluating the Compound Annual Growth Rate (CAGR) for a potential investment is the final step in the process and also the primary reason for doing an SSG in the first place! 56 28

29 Let s pause a moment for some questions! 57 Estimating Future P/E Values P/E history of the stock Check the trends Does all the recent data fit? More recent data is more relevant Don t make future P/E projections that are higher than the historical averages. P/E history of the market in general P/Es of 30+ are considered high and are not maintained for long Average P/E of S&P 500 is about 16 Be conservative set reasonable expectations 58 29

30 PRACTICE, PRACTICE, PRACTICE! Set a goal to complete three SSG s in the next week and then discuss them with someone else! Discussing your judgments will help you refine them. 59 The more SSGs you prepare, the easier the process will become and the better you will understand how it all fits together

HOMEWORK: Project High and Low P/Es Use the same company (PEP,

growth rates Complete the SSG by making high and low P/E

make your decisions remind yourself that these are YOUR choices

31 HOMEWORK: Project High and Low P/Es Use the same company (PEP, KO, ABT, MHS, TJX or ISRG) that you used to project future growth rates Complete the SSG by making high and low P/E projections List your reasons for selecting the P/Es As you make your decisions remind yourself that these are YOUR choices Based on YOUR SSG: Is the stock a buy, hold or sell? What is the up-side down-side ratio? What is your expected total return? 61 I BI The SSG process works! Use the SSG to become a BetterInvestor! 62 31

32 Review/Q&A Wrap-Up SO NOW WHAT???? AN INTERACTIVE DISCUSSION WITH KEN AND PAT ABOUT YOUR STOCK SELECTION GUIDES! Tuesday, April 12 7:30 PM to 9:30 PM Eastern Time This session will give you the opportunity to ask specific questions about judgments you have made on your practice SSGs. Come to listen or to ask questions! 63 Using the Online SSG A complete walkthrough of the BetterInvesting Online Stock Analysis Tool Thursday, March 31, :00 9:15 pm EDT

April 6, 2011 8:00 9:00 pm EDT www.betterinvesting.

33 Online Stock Study Abbott Laboratories (ABT) Carol Theine President, Puget Sound Chapter Wednesday, April 6, :00 9:00 pm EDT

DETERMINING A FAIR PRICE

DETERMINING A FAIR PRICE Disclaimer: All stock references are meant to be used for educational purposes. No recommendation for purchase or sale is intended or implied. Ken Kavula President Mid-Michigan