Equity Analysis: Part 2
Contents
Different Ratios: ..................................................................................................................... 2
P/E Ratio Relation with Growth & Risk .................................................................................. 3
Trailing & Forward P/E Ratio: ................................................................................................ 3
Comparing P/E Ratios Across Time and Industry: ................................................................. 3
Entry and Exit P/E: ............................................................................................................... 4
Enterprise Value (EV) .............................................................................................................. 4
EV/EBITDA Ratio:.................................................................................................................... 5
Quality of Business ................................................................................................................ 5
Operational Ability: ............................................................................................................. 5
Capital Allocation Ability: .................................................................................................... 5
Ansoff Matrix and Capital Allocation: ................................................................................... 6
Value vs Growth ..................................................................................................................... 7
Dividend Discount Model (DDM) ............................................................................................. 7
Discounted Cash Flow (DCF) Model........................................................................................ 7
Books to read ......................................................................................................................... 8
Ankit Pantula Notes P a g e |1
Different Ratios:
Ratios are indeed a snapshot of a company's financial health and market perception at a given point in
time. They are widely used in equity analysis to compare companies within an industry or to assess a
company's historical performance.
P/E Ratio (Price-to-Earnings Ratio):
• This is one of the most commonly used valuation metrics. It compares a company's current share
price to its earnings per share (EPS). A high P/E ratio might suggest that a stock is overvalued, or it
might indicate that investors expect high earnings growth in the future. Conversely, a low P/E ratio
could signal an undervalued stock or reflect lower expected growth or higher risks.
• The formula you provided, P/E ratio = Price per share / EPS, is correct.
• However, the notation "P0/Pe1" seems to imply the price at time zero (P0) divided by the expected
earnings in the next period (Pe1). This would be a forward P/E ratio, which uses forecasted earnings
rather than past earnings.
ROE (Return on Equity):
This ratio measures a company's profitability relative to the equity held by shareholders. It is calculated
by dividing net income by shareholder equity. A higher ROE indicates that a company is more efficient at
generating profits from its equity base.
The formula for ROE is:
ROE = Net Income / Shareholder Equity
This formula demonstrates how effectively a company generates profit from the equity invested
by shareholders.
𝑫𝟏 𝑬𝟏 (𝟏 − 𝒃)
𝑷𝟎 = =
𝒌−𝒈 𝒌 − (𝒃 × 𝑹𝑶𝑬)
• P_0 is the current price of the stock.
• D_1 is the expected dividend in the next period (year 1).
• k is the required rate of return or discount rate.
• g is the constant growth rate of dividends.
• E_1 is the expected earnings in the next period (year 1).
• b is the retention ratio (the proportion of earnings retained or reinvested in the company).
• ROE is the return on equity.
This expression can be thought of as a "forward P/E ratio" because it uses expected future earnings ((E_1))
instead of past earnings ((E_0)). The "forward P/E ratio" tells us how much investors are willing to pay for
each dollar of expected earnings, considering the company's dividend policy, growth prospects, and
required rate of return.
Ankit Pantula Notes P a g e |2
P/E Ratio Relation with Growth & Risk
1. Growth Rate (g) and P/E Ratio: A higher growth rate (g) typically leads to a higher P/E ratio, all
else being equal, because it implies that the company's earnings will grow at a faster rate in the
future, which makes the stock more attractive to investors. They are willing to pay more for the
stock now in anticipation of higher earnings later.
2. P/E Ratio and Required Rate of Return (k): The P/E ratio is indeed inversely related to the
required rate of return (k). If the required rate of return increases, the present value of future
earnings decreases, which would lead to a lower P/E ratio, assuming that future earnings
estimates remain unchanged.
3. P/E Ratio Interpretation: The P/E ratio does not solely determine whether a stock is
overvalued or undervalued.
A high P/E ratio could indicate that investors expect high earnings growth, high performance, or
that the company has a competitive advantage that justifies a premium valuation. Conversely, a
low P/E ratio could indicate that the market has lower expectations for growth or perceives higher
risk.
4. Risk and P/E Ratio: If the perceived risk of a company is expected to increase in the future, it
could lead to a higher required rate of return (k), which would put downward pressure on the
P/E ratio. Investors demand a higher return to compensate for the increased risk, which lowers
the price they are willing to pay for a given level of earnings.
5. Change and Return: The potential for change, whether in the company's performance, industry
dynamics, or broader economic conditions, can create opportunities for return. Analyzing and
understanding these changes can help investors identify when a stock's risk-reward profile
has shifted, potentially before this is fully reflected in the stock's price.
In summary, the P/E ratio is a complex metric influenced by various factors, including growth
expectations, required rates of return, and perceived risk. While it is a useful tool for valuation, it should
be used in conjunction with other analyses to gain a comprehensive understanding of a stock's
potential. Investors should consider both quantitative and qualitative factors, including company
fundamentals, industry trends, and macroeconomic indicators, to make informed investment decisions.
Trailing & Forward P/E Ratio:
The P/E ratio is a key metric in equity analysis, and it can be calculated in different ways to provide
insights into a company's valuation. Let's explore the concepts you've mentioned:
• P0/E0 (Trailing P/E): This is the trailing price-to-earnings ratio, which divides the current stock
price (P0) by the earnings per share over the past 12 months (E0). It reflects what investors are
currently paying for a dollar of the company's earnings based on historical performance.
• P0/E1 (Forward P/E): This is the forward price-to-earnings ratio, which divides the current stock
price (P0) by the expected earnings per share for the next 12 months (E1). It provides an
indication of what investors are willing to pay for future earnings, based on analysts' forecasts or
company guidance.
Comparing P/E Ratios Across Time and Industry:
• Across Time: By comparing a company's P/E ratio over time, investors can assess how the
market's valuation of the company has changed. An increasing P/E might suggest that investors
Ankit Pantula Notes P a g e |3
are expecting higher growth or that the company's risk profile has improved. A decreasing P/E
might indicate the opposite.
• Across Industry: Comparing P/E ratios across different industries can provide context for what
constitutes a "normal" valuation within a sector. Some industries naturally have higher P/E ratios
due to higher growth prospects, while others have lower P/E ratios due to being more mature or
facing greater risks.
Entry and Exit P/E:
• Entry P/E: The P/E ratio at the time of buying a stock can influence the investment's return.
Buying at a lower P/E ratio can provide a margin of safety and potentially higher returns if the P/E
ratio expands over time.
• Exit P/E: The P/E ratio when selling a stock is crucial because it determines the realized price. If
the exit P/E is higher than the entry P/E, it can significantly enhance returns, assuming earnings
have remained stable or grown.
Cost of Capital (k) and Growth:
• If the cost of capital is decreasing and growth is increasing, it can be a positive sign for a
company. A lower cost of capital means the company can finance its operations and growth
initiatives more cheaply, potentially leading to higher valuations.
10-Year CAGR and Operating Cash Flow:
• 10-Year CAGR (Compound Annual Growth Rate): This metric provides a better
understanding of a company's performance over a longer period, smoothing out short-
term fluctuations. It shows the annualized growth rate of an investment over a 10-year
period.
• 10-Year Operating Cash Flow: Analyzing a decade's worth of operating cash flow can
give a more comprehensive view of a company's cash-generating ability, which is critical
for sustaining operations and funding growth. It captures the company's financial health
over time, rather than just a snapshot provided by the P/E ratio.
Enterprise Value (EV)
Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive
alternative to market capitalization. It takes into account not only the equity value but also the debt level
and cash on the company's balance sheet. Here's how it's calculated:
[ EV = Market Capitalization + Total Debt - Cash and Cash Equivalents]
Where:
• Market Capitalization is the total value of a company's outstanding shares of stock.
• Total Debt includes short-term and long-term debt.
• Cash and Cash Equivalents are the liquid assets that a company can quickly convert to cash.
The rationale behind this calculation is that if you were to purchase the entire company, you would have
to buy all the outstanding equity (market capitalization), assume the company's debt, and you would get
the benefit of the company's cash reserves.
Ankit Pantula Notes P a g e |4
EV/EBITDA Ratio:
The EV/EBITDA ratio compares the Enterprise Value of a company to its Earnings Before Interest, Taxes,
Depreciation, and Amortization (EBITDA). This ratio is used to determine the value of a company relative
to its earnings before accounting for financial and tax structures, as well as non-cash charges. It's a
common valuation metric because it provides a clearer picture of a company's operational performance
by excluding non-operating expenses and the effects of different capital structures.
A lower EV/EBITDA ratio can be interpreted as the company being undervalued relative to its earnings
potential, suggesting that it might be a better investment opportunity. It indicates that an investor would
need to spend less to acquire one dollar of the company's EBITDA, which could be seen as a "payback"
period in terms of operational earnings.
However, it's important to note that "better" or "worse" is relative and can vary by industry. Different
industries have different average EV/EBITDA ratios, so it's crucial to compare a company's ratio to its
industry peers. Additionally, the ratio should be used as part of a broader analysis, including an
examination of the company's growth prospects, profitability, debt levels, and other financial metrics.
In summary, Enterprise Value provides a more complete picture of a company's total value by including
debt and cash, and the EV/EBITDA ratio is a useful tool for comparing companies on an operational level,
taking into account their different capital structures and non-cash expenses. However, like any financial
metric, it should not be used in isolation when making investment decisions.
Quality of Business
The quality of a business can be assessed through various lenses, two of which are operational ability and
capital allocation ability. These aspects are critical for understanding how well a company is managed
and its potential for long-term success.
Operational Ability:
Operational ability refers to how efficiently and effectively a company runs its day-to-day operations. It
encompasses a range of factors, including:
Capital Allocation Ability:
Capital allocation refers to how a company uses its financial resources to maximize shareholder value.
This includes decisions about investing in growth, paying dividends, repurchasing shares, and managing
debt. A company with strong capital allocation ability will:
Ankit Pantula Notes P a g e |5
Ansoff Matrix and Capital Allocation:
The Ansoff Matrix is a strategic planning tool that companies can use to determine their strategy for
growth. It presents four main strategies based on product and market focus:
1. Market Penetration: Selling more of the existing products to the current market. This strategy
involves minimal risk and focuses on increasing market share through pricing strategies,
marketing, or sales initiatives.
2. Product Development: Developing new products for the existing market. This strategy requires
investment in research and development and can lead to growth by meeting evolving customer
needs.
3. Market Development: Entering new markets with existing products. This can involve geographic
expansion or targeting new customer segments and requires understanding of new market
dynamics.
4. Diversification: Introducing new products to new markets. This is the riskiest strategy as it
involves both product and market development, but it can also provide opportunities for
significant growth.
In terms of capital allocation, the Ansoff Matrix can guide where a company should invest its resources to
achieve its growth objectives. For example, a company might allocate capital to marketing efforts to
penetrate a market more deeply or to R&D for product development. The key is to align capital allocation
decisions with the strategic growth path the company intends to pursue, as outlined by the Ansoff Matrix.
In conclusion, the quality of a business is significantly influenced by its operational ability and capital
allocation ability. These competencies are essential for sustainable growth and value creation, and they
should be carefully evaluated by investors when analyzing a company's long-term prospects.
Ankit Pantula Notes P a g e |6
Value vs Growth
Attribute Value Investing Growth Investing
Pricing Relative Lower priced than market Higher priced than market
to Market
Industry Priced lower in the industry Often priced at a premium in the
Valuation industry
Earnings Growth May have lower or more stable growth High earnings growth rates
rates
Market Volatility Less volatile than the market More volatile than the market
(generally)
Investment Focus on margin of safety Focus on high growth potential
Focus
Current May not be doing well currently, but Doing well currently with
Performance have potential for improvement expectations of continued success
Investor Outlook Looking for undervalued companies Willing to pay a premium for
that are expected to revert to intrinsic companies with strong future growth
value prospects
Dividend Discount Model (DDM)
The formula for the Gordon Growth Model, which is a type of DDM, is:
Current Stock Price (P0) = Dividend Per Share Next Year (D1) / (Required Rate of Return (r) -
Dividend Growth Rate (g))
In this formula:
• P0 is the current stock price.
• D1 is the expected dividend per share for the next year.
• r is the required rate of return or discount rate.
• g is the expected growth rate of dividends per year.
Discounted Cash Flow (DCF) Model
The DCF model involves calculating the present value of the expected free cash flows over a
forecast period and the present value of the terminal value (the value of the company's cash
flows beyond the forecast period). The formula for the DCF model is:
Company Value = Present Value of Forecasted Free Cash Flows + Present Value of Terminal
Value
Ankit Pantula Notes P a g e |7
To calculate the present value of forecasted free cash flows, you would:
• Estimate the free cash flows for each year of the forecast period.
• Discount each year's free cash flow back to the present using the Weighted Average
Cost of Capital (WACC).
To calculate the present value of the terminal value, you would:
• Estimate the terminal value using an appropriate method (such as the perpetuity growth
model).
• Discount the terminal value back to the present using the WACC.
Finally, you add the present value of the forecasted free cash flows and the present value of the
terminal value to arrive at the total company value.
Both models are used to estimate the intrinsic value of a company's stock, but they approach
the valuation from different perspectives. The DDM focuses on the value of expected dividend
payments, while the DCF model considers the value of all future free cash flows generated by
the company.
Books to read
The Black Swan" by Nassim Nicholas Taleb: "The Black Swan" explores the concept of highly
improbable events that have a massive impact on the world. These events, termed "Black
Swans," are unpredictable and often dismissed as outliers. Taleb discusses how our inability to
foresee Black Swans has profound implications, particularly in financial markets, and he
advocates for building systems that can withstand, or even benefit from, unexpected events.
"Antifragile: Things That Gain from Disorder" by Nassim Nicholas Taleb: In "Antifragile," Taleb
introduces the idea of antifragility, a quality of systems that actually improve when exposed to
volatility, randomness, and stressors. The book covers how to identify and cultivate antifragility
in various domains of life and encourages embracing uncertainty and chaos as opportunities for
growth, rather than merely resisting them.
"Poor Charlie's Almanack: The Wit and Wisdom of Charles T. Munger" edited by Peter D.
Kaufman: This book is a collection of speeches and wisdom from Charlie Munger, Warren
Buffett's partner at Berkshire Hathaway. It presents Munger's approach to business, investing,
and life, emphasizing the use of a broad set of mental models to make better decisions. The
book is a tribute to Munger's intellectual curiosity and multidisciplinary mindset.
"Common Stocks and Uncommon Profits" by Philip A. Fisher: Philip Fisher's classic book on
investing focuses on identifying companies with the potential for long-term growth. Fisher
outlines what he calls the "Fifteen Points to Look for in a Common Stock," a set of criteria for
evaluating a company's quality and growth prospects. He emphasizes the importance of
qualitative factors, such as management's integrity and innovation, in the investment decision-
making process.
Ankit Pantula Notes P a g e |8
