Is the price right?

Taking the example of Tata Power,let us learn how this approach works.

Key inputs

You need the following information to do the calculations: current price of the stock,latest 12-month trailing EPS earnings per share,historic average PE of the stock we have taken five-year average,and historic growth rate in earnings we have calculated five-year CAGR. Instead of historic growth rate in earnings,you could also obtain analysts consensus estimate of expected growth rate in earnings for that stock. And finally,you need to know the average dividend payout ratio which is dividend divided by EPS of the stock again we have taken the five-year average.

Using these inputs,we calculate what return you could earn from the stock over the next five years. The total returns from the stock will be the sum of the price of the stock at the end of the fifth year and the dividends you earn from it during those five years.

How do you calculate the price that the stock will command at the end of five years? You first calculate its EPS at the end of five years by compounding current EPS by a rate that is one of the two: either the past five-year average growth rate,or analysts consensus estimate of earnings growth rate for the next five years.

In the current example,the EPS of Rs 39.42 will in five years grow to Rs 66.61 using the historic five-year average growth rate of 11.06 per cent. If we multiply this EPS by the historic average PE 18.39,the price the stock is likely to command comes to Rs 1,224.86.

Next,we calculate the average dividend payout ratio of the stock comes to 0.25. We multiply this with the EPS of each of the next five years to get the dividend paid by the stock each year. The sum total of dividend paid during the next five years Rs 68.24 is added to the stock price Rs 1,224.86 to get the total return that the investor is likely to earn from the stock Rs 1,293.11.

Now,if we pay the current price of Rs 846.85 and expect a return of 15 per cent,then the total return from the stock should have been Rs 1,703.32. But the total return we get Rs 1,293.11 falls short of this mark.

We now discount this return Rs 1,293.11 by 15 per cent annually for five years to get a price in this case Rs 642.90. This is the maximum price that an investor should pay for this stock if he wants a 15 per cent return from it.

Points to note

The 15 per cent rule is not sacrosanct. For the Indian markets you could perhaps use a slightly higher required rate of return a calculation of the required rate of return can be done using the capital asset pricing model or CAPM.

As you can see,this method of calculation is based on the premise that history is a guide to a stocks future performance in terms of EPS growth rate,dividend payout ratio and PE level. By using analysts consensus estimate for earnings growth which is likely to be lower than the five-year historic growth rate,you would perhaps be closer to the mark since earnings growth tends to slow down as a company matures.

If,as in the case of Tata Power,the maximum that you can pay is less than the current price of the stock,the investor would be well advised to put the stock on his watch list. If the price falls to the required level,he should purchase it. If not,he should abstain despite the stocks desirability in terms of growth expectations. u

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