STOCK STUDY WORKSHOP
SECTION 3 & 4 OF THE SSG, INFOSYS TECHNOLOGIES LT. (IFSY)
RALPH SEGER, CFA
NOW TO SEPARATE THE SHEEP FROM THE GOATS.
The SSG requires important judgments. The end result will be no better that the judgments and estimates of the analyst. We have already seen the judgments required to estimate future growth rate of sales, pre-tax profits and EPS. We have examined percent pre-tax profit on sales and percent earned on equity capital. Since these estimates were reasonable and favorable we continue our analysis.
Sections 3 and 4 provide us with estimate of future P/E ratios, future high and low prices, the risk of this investment and the important expected total return over a five year period.
Section 3 is the five years price range of the stock and price/earnings ratio during the same period. Again, Toolkit puts the necessary data in the right spots and makes the necessary calculations. My SSG for INFY is part of this STOCK STUDY. You are encouraged to look at it as I go through the process of Sections 3 & 4 of the SSG.
[You can download Ralph's SSG or ITK file from the first session, or look at the PDF file of his completed SSG in Session 2]
In Section 3 of the SSG are the high and low prices in columns A and B. In column C are the reported EPS. In columns D and E are the calculated Price/Earnings ratios, both high and low. Note that I have crossed out calculated P/E ratios for 2002 through 2005. These values are much too high to be expected to repeat in the future. Here again judgment must come into play. I have selected a future growth rate of 20% per year for sales, pre-tax profits and EPS. If we use 20% as the denominator in calculating price earnings/growth ratios (PEG) the calculated P/E ratios for 2002 to 2005 will produce high PEG ratios of 238 to 207. These are unreasonably high. I have found from experience that a PEG ratio above 150 after buying a stock suggests that the stock is overpriced in many instances. Even after crossing out unrealistic high P/E ratios the suggested average shown in Section 3, line 7 and columns D and E are unrealistically high in my judgment.
Therefore in Section 4 I have made a judgment to use a high P/E of 30 as the expected high, and 20 as the expected low in section 4 line A and section 4 line B(a). These are respectively calculations for estimating possible future high and low prices for INFY.
The multiple of the expected high P/E ratio of 30 times the projected EPS (from the visual analysis) of $4.81 produces an expected high price of $144 in five years IF ALL GOES WELL. This is my optimistic judgment.
Of course prices of stocks can go down too. In section 4 line B- (a) through (d) are several suggestions as to estimating a future low price. Several cautions need to be pointed out.
1. Do not select a future low price that is higher than the 52 week low as this is the actual market.
2. Ignore (b) average low price of the last 5 years. In my judgment this is nonsense for a growth stock.
3. Ignore (d) price a dividend will support. INFY pays no dividend. Further, growth stocks tend to have low payout of dividends as a percent of EPS. It is unreasonable to expect to estimate a future low price of a classic growth stock based on support by a dividend.
That leaves me with two options:
(a) Average low P/E as a multiple of expected low EPS.
(d) Recent severe market low price.
In my opinion, Toolkit is deficient in using (d) because it picks the low price of a year earlier. As we have probably learned in early 2008 this does not reasonably estimate a future low price. When we encounter a bear market it is “Casey bar the door”.
In my case I selected (a) average low price (in this case my judgment as to the future low P/E) as a multiple of estimated low EPS. The Tool Kit picks the EPS reported for the last fiscal year in section 3, line 5, column B of $1.50 EPS. I went to PERT Worksheet-A and noted EPS for the 12 months ending December 2007 were $1.93. An EPS of $1.93 as a multiple of my judgment of the future estimated low P/E of 20 produces an estimated low price of 38.6 which I insert as the Selected Estimated Low Price in section 4. HOWEVER, I have goofed, in that the 52 week actual low this year is 35 as shown in the top line of section 3.
Please note that I have ignored the so called preferred procedure. This procedure must take into consideration future sales, future profit margin, future number of shares out standing, future income tax rate and the future P/E ratio. That is a lot of estimating to be done.
When I was in an early investment club 50 years ago the preferred procedure was the standard procedure. Our club bought a major manufacture of air conditioning equipment. As time went by we noticed the future growth of EPS failed to develop because the company was issuing more shares to acquire other companies. We decided that historic growth of EPS would take into account all these variables. We presented our argument to George A. Nicholson, Jr. and he agreed with us. Thus was born the SSG using analyst’s estimate of future growth of EPS and the discard, in our club, of the so-called preferred procedure.
I wish to determine the risks of buying INFY at the current price. The method of analysis in section 4 presents several tools to help me make that judgment. Section 4 line C Zoning helps me in this problem.
The up side/down side metric is a calculation of the potential gain compared to the possible loss if we have to sell at the estimated low price. The US/DS ratio is divided into three parts.The difference between the estimated high price and the estimated low price is divided into 3 zones.
- The lower zone in 25% of the difference between the estimate of the high price lass the estimate of the low price.
- The middle zone is 50%of the difference between the top of the lower zone and the estimated high price.
- The upper zone is the remaining difference between the top of the middle zone and the estimate high price.
Please note that if the 25%, 50%, 25% the top of the lower zone will always be an up side/down side ratio of 3 to 1. If we use a 1/3, 1/3, 1/3 zoning the top of the lower zone will always be an up side/down side ratio of 2 to 1. I feel very strongly that before we buy the up side/down side ratio must be 3 to 1 or more. In other words the odds of potential profit must be at least 3 times the odds of potential loss. In my 50 years of experience in reviewing many club portfolios I have found that ignoring this rule leads to over paying for stocks and resultant poor investment performance.
Of course the top 25% zone is the danger area where the odds of losing money exceed the odds of making a profit.
As I have said previously it takes a P/E ratio expansion plus growth of EPS to move the price of a stock upward to generate a profit. Too many investors and investment clubs fail to pay attention to this truism .This leads us to Relative Value (RV) as a technique for valuing holdings or potential holdings.
In order for there to be an expansion of the P/E ratio, judgment must come into play as to what is reasonable to expect in the future. In sections 3 and 4 I have outlined my rational for estimating future P/E ratios. If past P/E ratios discount not only the future, but also the hereafter, then the use of historical P/E ratios in RV ignore the concept that it takes an expansion of P/E ratio to achieve a profit on your investment. When I make a judgment as to what future P/E ratios may prevail, I must make that judgment on the basis of logic and experience. If I throw logic out the window and use an average P/E ratio based on historic figures that are very unlikely to be repeated I set my self up for failure.
My concept of RV is the current P/E, based on analyst’s estimate of EPS 12 months in the future, as a percent of my estimate of a reasonable future average P/E ratio. If the RV is around 100 or so I know I have the chances of profit if all goes well. After all Wall Street analysts look into the future not back. Using a P/E ratio based on 12 months past EPS is like driving down a hilly mountain road looking at the rear view mirror instead of the front wind shield. Using P/E ratios based on 12 months reported EPS is dangerous to your wealth. Driving down a mountain road looking at the rear view mirror is dangerous to your well being.
Unfortunately, Toolkit's presentation of the PERT Report fails to take into account the judgment of the P/E ratios used in section 4. Instead it ignores the judgment made as to what is a logical P/E to expect in the future and uses the mechanical calculations of section 3, line 7, P/E ratio averages. If I have made a judgment that metrics of historic average P/E ratios are not logical then when using the PERT Report to help manage my portfolio I must calculate manually the RV for the PERT Report. I feel this is a very serious deficiency in Toolkit which I have tried to correct for several years, but have not yet persuaded those who control the programming of Toolkit as to my logic
Section 4 also contains the percent price appreciation and the calculation of RV, based on trailing 12 months EPS and Projected RV based on the 20% growth rate used in my analysis. The projected RV is of value in determining if the stock has the capability of a P/E ratio expansion to drive the price up to favorable levels.
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