Intelligent Investor's Notes: Vitaliy Katsenelson's Absolute PE Valuation Model

Companies are not equal in many aspects in terms of performance, efficiencies, capital structure (how much equity and debts is used), stability of earnings and cash flow, growth prospects, sizes, financial strength etc.
Companies with a higher growth expectation, a healthier balance sheet, more stable earnings etc should be accorded higher P/E ratios.

Absolute PE was created by Vitaliy Katsenelson and explained in his book Active Value Investing will able to overcome above issues. It is a able to determine what is a fair PE for a company.
Absolute PE uses five conditions to come up with a fair value multiple.

There is some subjectivity involved - you are required to grasp an understanding of the business to identify the level of risk involved.
No Growth PE - PE range of 7 to 8.5 is perfectly acceptable so you are free to use whatever suits you. Graham used 8.5 (11.8%) in his formula while Katsenelson use 8 (12.5%) in his book; and Jae Jun is using PE of 7 (14.2%). !!! Small caps use 7 (14.2%) while big cap use 8.5 (11.8%)
Higher Growth Rate leads to a higher PE - however this model does not have a linear relationshop. Absolute PE model - Every % of Earning Growth from 0% to 16%, PE increased by 0.65 points. If growth rate reach 17%, the PE increase 0.5 points. !!! The higher the growth rate, the greater the fall from the top.

Earning growth projections are made for 5 years (or longer) and with higher earning visibility - higher PE factor is assigned - e.g. The earning visibility of Coca Cola or Microsoft is clearer than Salesforce or Cyclical Company like Caterpillar

Value of Dividends - it is tangible to investor (whereas earnings is not). Thus, it have a linear relationship between DY and PE - every DY% receives and equivalent PE point. If DY% < 1%, use a PE factor of 0.5.
Business & Financial Risk, Earnings Visibility - The most subjectivepart - it requires you to come up with a single number to summarize the risks and earnings visibility.
Business Risk - What industry the company is in? The products, the life cycle, the concetration of products and customers, enviromental risks, and anything else related to the operations of the business.
Jae Jun identified four numbers to quantify business risks

ROE, ROA, CROIC - Businesss Capable of sustaining above average returns or increasing returns each years has a good busines model, moat & capable management.
Intagibles % of Book Value - to prevent businesses grow by acquisitions which could lead to issues later on - growth through intangibles is not a good business model and is not a competitive advantage. !!! High intangibles not necesarily a business risk, but continually growing intangibles is a warning sign.
Financial Risk -Examining the capital structure, the strength of the cash flow in relation to debt and interest payments.
Jae Jun identified four numbers to quantify financial risks

Current Ratio
Total Debt/Equity Ratio
Short Term Debt/Equity Ratio - a large upcoming debt payment is much more worrisome than a low interest, long term det due in 10 years.
FCF to Total Debt - displaying financial strength - it shows whether the company is able to pay back its debt through FCF instead of using new debt to finance old debt.

Average Company - 1
Market Leader - < 1. If you believe market leader deserves 10% premium use 0.9; 15% premium then 0.85.
Market Lagger - > 1. Poor companies should be discounted e.g. 20% discount use 1.2.

A firm has to have stable margins, stable or increasing earnings and cash from operations. FCF or owner earnings is rathr volatile and not a good measurement for predictability.
Put a Ceiling

Basic P/E = No Growth PE + Earning Growth Point + DY Point
Fair Value P/E = Basic P/E + Adjustment of Business Risk, Financial Risk & Earnings Visibility
Katsenelson limit the premium to basic PE to be no more than 30%

Inflation & Interest Rate - the model assumes that inflation and interest rates are average and not expected ot increase or decrease to dramatic new levels. If inflation and interest rate are expected to rise, 0 growth PE should be adjusted down and Vice Versa
Fair Value P/E = Basic PE x [1 + (1 - Business Risk)] x [1 + (1 - Financial Risk)] x [1 + (1 - Earnings Visibility)]
Let's take PTARAS as a case study and see what is the fair value P/E and it's intrinsic value based on absolute P/E valuation model. The valuation is conducted based on FY 2013 result.

No Growth P/E - 8 (market cap - 700M+)
Earning Growth - 7.5% (average 10 year growth rate derrived from div payout % and ROE); Earnings Growth Points - 7.5 * 0.65 = 4.875
DY - PTARAS paid 0.25 sen dividend on Year 2013 (before bonus issue). I assume PTARAS paid the same amount of dividend 0.25/2 = 0.125. The dividend yield based on stock price of 4.38 will be 0.125/4.38 = 2.85%; DY Point = 2.85
Basic PE = 8 + 4.875 + 2.85 = 15.725
Business Risk - in view of the high ROE and ROIC, the business risk is low. I will rate it as 0.9.
Financial Risk - PTARAS has no debt and have a healthy cash flow - 0.9.
Earning Visibility - the earning margin is high and it is stable - 0.9
Fair Value P/E = 15.725 x [1 + (1 - 0.9)] x [1 + (1 - 0.9)] x [1 + (1 - 0.9)] = 20.93
Adjusted EPS (due to bonus issue) based on FY 13 = 0.3265
Intrinsic Value = 20.93 * 0.3265 = 6.83

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Intelligent Investor's Notes