When is the share price right?

Simon Brown be­lieves that in­vestors shouldn’t just buy shares at any price, no mat­ter how great the stock. Here’s the method he uses to de­ter­mine what a de­cent price looks like for a given share.

Finweek English Edition - - MARKETPLACE - Edi­to­rial@fin­week.co.za

icon­stantly stress that we need to buy the best qual­ity com­pa­nies for our longterm in­vest­ment port­fo­lios. But hav­ing found that great share, the sec­ond part of the equa­tion is what price we should pay for it. Some will ar­gue that you should buy re­gard­less of price, but I dis­agree. A great com­pany at a bad price is a bad in­vest­ment. We need to get a great com­pany at a great price to see our long-term port­fo­lio do well.

The prob­lem is: what is a great price? Some peo­ple will use dis­counted cash flow (DCF), oth­ers will look at the price-to-book ra­tio (P/B) or use vari­a­tions of the div­i­dend dis­count method. At the end of the day all these meth­ods are sub­jec­tive, and in all cases one must make many as­sump­tions about prof­its, growth, mar­gins and more. Ev­ery time you as­sume some­thing, you add risk to your pre­dic­tion, as that as­sump­tion could be wrong.

So, I keep it sim­ple, very sim­ple. I gen­er­ate a chart of the his­toric price-to-earn­ings ra­tio (P/E) over the last seven years, and look to buy when the for­ward P/E is be­low the seven-year av­er­age. I use seven years as this is a full eco­nomic cy­cle.

The first point is where to find the data. I get the P/E ra­tio at ev­ery year-end and in­terim pe­riod from my on­line bro­ker. If your bro­ker does not of­fer this in­for­ma­tion, you’re go­ing to have to do some dig­ging. Google Fi­nance will pro­vide the price at ev­ery pe­riod end and in the re­sults you’ll find the head­line earn­ings per share (HEPS) num­bers, and you can then cal­cu­late your P/E for the end of ev­ery pe­riod.

Drop this data into Ex­cel and gen­er­ate the av­er­age for the seven years (14 data points) and you’ll get a chart like the one on this page for Woolies*. Here we can see that the av­er­age P/E over the last seven years has been 18.9 times, and I will con­sider buy­ing if the for­ward P/E is be­low this level.

The for­ward P/E is gen­er­ated us­ing the cur­rent share price and next year’s ex­pected HEPS. Again, my bro­ker pro­vides con­sen­sus fore­casts for fu­ture earn­ings, but if yours does not or if the share you’re look­ing at is not cov­ered, you can make a rough es­ti­mate. Be con­ser­va­tive rather than op­ti­mistic. Here the for­ward P/E is around 14.8 times, so at a cur­rent price of 7 200c, my sys­tem con­sid­ers Woolies to be of­fered at a great price to buy. I take this a step fur­ther by ask­ing up to what price I’ll be pre­pared to pay for Woolies shares. Here the for­mula is av­er­age P/E / for­ward P/E * cur­rent share price, where av­er­age P/E = 18.9 times, for­ward P/E = 14.8 times and cur­rent share price = 7 200c. This equates to: 18.9 / 14.8 * 7 200c = 9 195c. So, I will buy up to 9 195c.

Capitec*

Let’s do the same us­ing this bank. Av­er­age P/E is 16.2 times and for­ward P/E us­ing its re­cent trad­ing state­ment is around 23.5 times. So, at the cur­rent price of R758 the for­mula is 16.2 / 23.5 * R758 = R522. That R522 is the price at which I would buy Capitec and for now I wait, not adding to my Capitec po­si­tion.

The buy price will change as new re­sults come out and as for­ward ex­pec­ta­tions change. Very im­por­tantly, this buy price does not mean that the price can­not fall fur­ther; with Woolies we see that the cur­rent price is well be­low my buy price. This buy price I con­sider fair value and I will stag­ger my buy­ing over time be­low the fair value price.

The method is quite rough and any for­ward pre­dic­tions are far from per­fect, but it has served me well over the years.

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