Page 165 - DMGT553_RETAIL_STORE_MANAGEMENT

Retail Store Management

Notes past several quarters / years because of cost cutting, but their sales growth could be only 0–5%.
This would signal that their earnings growth will probably slow when the cost cutting has fully
taken effect. Therefore, forecasting an earnings growth closer to the 0–5% rate would be more
appropriate rather than the 15–20%. Nonetheless, the growth rate method of valuations relies
heavily on gut feel to make a forecast. This is why analysts often make inaccurate forecasts, and
also why familiarity with a company is essential before making a forecast.
Price Earnings to Growth (PEG) Ratio: This valuation technique has really become popular
over the past decade or so. It is better than just looking at a P/E because it takes three factors into
account; the price, earnings, and earnings growth rates. To compute the PEG ratio, divide the
Forward P/E by the expected earnings growth rate (you can also use historical P/E and historical
growth rate to see where it’s traded in the past). This will yield a ratio that is usually expressed
as a percentage. The theory goes that as the percentage rises over 100% the stock becomes more
and more overvalued, and as the PEG ratio falls below 100% the stock becomes more and more
undervalued. The theory is based on a belief that P/E ratios should approximate the long-term
growth rate of a company’s earnings. Whether or not this is true will never be proven and the
theory is therefore just a rule of thumb to use in the overall valuation process.
Here’s an example of how to use the PEG ratio. Say you are comparing two stocks that you are
thinking about buying. Stock A is trading at a forward P/E of 15 and expected to grow at 20%.
Stock B is trading at a forward P/E of 30 and expected to grow at 25%. The PEG ratio for Stock A
is 75% (15/20) and for Stock B is 120% (30/25). According to the PEG ratio, Stock A is a better
purchase because it has a lower PEG ratio, or in other words, you can purchase its future earnings
growth for a lower relative price than that of Stock B.

Sum of Perpetuities Method

The PEG ratio is a special case in the Sum of Perpetuities Method (SPM) equation. A generalized
version of the Walter model (1956), SPM considers the effects of dividends, earnings growth, as
well as the risk profile of a firm on a stock’s value. Derived from the compound interest formula
using the present value of a perpetuity equation, SPM is an alternative to the Gordon Growth
Model. The variables are:

P is the value of the stock or business
E is a company’s earnings
G is the company’s constant growth rate

K is the company’s risk adjusted discount rate
D is the company’s dividend payment

In a special case where K is equal to 10%, and the company does not pay dividends, SPM reduces
to the PEG ratio.

Nerbrand Z. Given that investments are subject to revisions of future expectations the Nerbrand
Z utilises uncertainty of consensus estimates to assess how much earnings forecasts can be
revised in standard deviation terms before P/E rations return to normalised levels. This
calculation is best done with I/B/E/S consensus estimates. The market tends to focus on the
12 month forward P/E level but this ratio is dependent on earnings estimates which are never
homogenous. Hence there is a standard deviation of 12 month forward earnings estimates.

160 LOVELY PROFESSIONAL UNIVERSITY