QUALIPORT
Four Quick Valuation Rules

By Bruce Jackson (TMFGoogly)
December 14, 2000

Falling markets present buying opportunities. The Qualiport is sitting on over £5,500 of cash, so we're ready to pounce should some opportunities arise. Maynard has some ideas, and will elaborate more on Monday.

Suffering

The Qualiport is suffering. We've lost money this year, and have almost certainly lost in the race versus the index. Despite this, it could easily have been a lot worse.

During the technology and Internet share boom of March this year, we weren't tempted to dive in. We sat on our hands whilst many tin pot companies saw their share prices rise to levels simply beyond belief. The share prices of many good companies were also carried along on this wave of greed and irrationality.

RM (LSE: RM.) was one such company. It supplies integrated IT solutions to the educational market. With the Government's pledge to have every school connected to the Internet, this is most definitely a growth market. On face value, RM looked a good long-term investment prospect  until you looked at the valuation.

The current share price stands at 523p. Earlier this year, they peaked at 1048p. As Benjamin Graham used to say, it only takes a fall of 50% to wipe out the previous 100% gain. This was Graham's way of warning that the ride down can be faster than the ride up. I pity those who bought at the peak, and who are now sitting on a loss of 50%. They will have to wait a long time to get their money back, if they ever do.

At 1048p, RM traded on a forecast price to earnings ratio (P/E) of 75. Today, RM trades on a forecast September 2002 P/E of 33. That's still far too expensive for the Qualiport. From here on, RM shares may rise. They may fall. But there's a high percentage chance they'll still provide less than average returns over the next 5 years.

That's because, over time, the P/E ratio of most companies eventually reverts to the norm. There are of course the exceptions, such as Glaxo Wellcome (LSE: GLXO) in the UK and Coca-Cola (NYSE: KO) in the US. Those two companies are massive, and courtesy of their size and market dominance, probably deserve to have premium ratings. Even still, Glaxo Wellcome traded on a P/E of 18 as recently as 1996, and Coca-Cola has seen its P/E fall from 60 to 40 over the last couple of years.

What Is The Norm?

This is the $64,000 (£44,137.93) question. You can't look at the P/E of a company in isolation and say "yep  it's under- or overvalued". That's because the P/E is dependent on the company's growth rate. If a company is forecast to grow consistently at 20% per annum for the next 5 years, it deserves a premium P/E. On the other hand, if it's growing at 5% per annum, it deserves a low P/E.

Many investors tend to forget that over time, growth rates of most companies tend to revert to the norm. It is actually very difficult to grow earnings materially faster than inflation over an extended period of time. At this stage it is worth remembering that most quoted companies make poor investments.

Fair Value P/E

When calculating what a fair P/E is for a company, I use these four rules.

1. Use the base interest rate. It currently stands at 6%. That equates to a fair value P/E of 16.67 (1/6%). For good companies, I consider this P/E to be the norm. Remember, most companies are poor companies, and they will rightly trade on a P/E far lower than the norm.

2. Look forward. Look past the projected growth rate for the next 2 years. Assume a best case 8% annualised growth rate 5 years from now. That's because you should assume a fast growing good company will be trading on a fair value P/E in 5 years' time.

3. There are always exceptions, but these are rare.

4. The P/E is not the only valuation tool. However this methodology can give you a quick fix on what might be the fair value P/E for a company.

An Example

Let's use RM as an example. The assumed growth rate is 12% per annum.

Year  EPS

2001  14.0
2002  15.7
2003  17.6
2004  19.7
2005  22.0
2006  24.7

After 5 years of solid earnings growth, under this scenario RM is expected to earn 24.7p per share in 2006. After that, it should be able to grow earnings at 8% per annum, so we'll award them the fair value P/E of 16.67. That means that in 2006, the shares may trade at 411.75p (24.7p * 16.67). Compared to their share price today of 523p, you'd be losing money over the next 5 years. Yikes!

Set up a simple spreadsheet and play with all the assumptions until your heart is content. For example, if you thought RM could grow earnings by 20% per annum for the next 5 years, and that interest rates in 2006 would be 4%, you could make a case for the RM share price being 870p (34.8p * 25) in 2006.

Minimise The Downside

Successful investors buy shares when the odds are in their favour. Instead of making investments based on best-case scenarios, they look at them from a worst case. How much further can these shares fall? What can go wrong? They would NOT invest in RM  the downside is not minimised.

Conclusion

Valuation matters. It matters a lot. As the Qualiport searches for investment opportunities, we'll be looking to buy good companies. We'll buy them when the downside is minimised, using amongst other things, our four quick P/E valuation rules.

Where Next?

" All feedback and thoughts encouraged to the Qualiport discussion board. bbbb