Stock Valuation by looking at Future Earnings

by admin on June 4, 2011

I recently read an interesting article from “Fiver Capital” at Seeking Alpha, the article titled “Microsoft: Buy It Like Buffet” was very interesting to me; it introduced me a new concept to easily value stocks based on its historic price and price target (based on projected EPS).

First thing you need to do is to take pen and paper and write down these values for the stock you are considering buying:

  • Current price,
  • Current EPS,
  • Current PE and
  • Current earnings yield

What we will try to do here is to calculate the value of the stock in 5 years, if earnings yield continue its trend. At the end of the 5 years we will take this estimated EPS price to calculate the yearly profit by using the Compound Annual Growth Rate formula.   This is how it works:

Let’s take the example of Microsoft (MSFT) currently traded at $23.91 and Earning Yield at 10.27%, (that had been grown constantly over the past 10 years). The current EPS at MSFT is $2.52.

If we believe MSFT will continue this trend we can calculate future EPS based on this growth. To do this we need to use the formula for future value, this will give us a target EPS value of $4.11 in 5 years.

Let’s imagine for a moment that in 5 years this would be actually the case, and let’s multiply the future EPS by the current PE ratio of 9.47. This will give us a stock target price of $38.91

If that would be true in 5 years, (for MSFT most likely will be) we can now calculate what the Compound Annual Growth Rate (CAGR) of our investment would be at that point in time; on this example for MSFT our CAGR would be 10.23%, which in other words means that if I invest today in MSFT $23.91 today I’ll gain 10.23% yearly if the stock end up being worth $38.91 in 5 years.

Please notice that on this example in order to calculate the future price of the stock I apply the same PE of the stock as is trading today 9.47 which in my opinion is very conservative for a Multinational like MSFT, now if the company flourish on the next 5 years and its PE ratio increase we may be seeing a much better stock target price. MSFT could be could be a very good investment for the next 5 years.

Something important to consider when analyzing this data is to check if the company is purchasing stock, Microsoft has repurchased 1,056 Million shares over the past few years so the EPS still growing even though this is an artificial effect, the less shares on the market the biggest the EPS, this practices is usually employed when the company is not growing as it used to and to avoid the stock from plummeting. With MSFT foot on the corporate world and the videogame industry I doubt the steady growth would be much of a concern, but be careful when considering other companies in particular decreasing markets.

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