With that said, let’s take a look at our previous example, RadioShack, for clarification.
- Stock Market Price: $3.35 (Oct 18, 2013)
- Current EPS (Earnings Per Share): $-2.71 (EST $0.50 in 2015)
- Estimated Future Growth Rate: 11%
- Weighted Average Cost Of Capital (WACC): 7%
- Average P/E (Price/Earning) Ratio To Use: 14.8
RadioShack presents us with an interesting real life valuation example that you will run into more than you can imagine. Particularly if you are looking for cheap value oriented stocks. First, you will notice that last year EPS were negative.
Well, we cannot perpetuate negative earnings into the future in order to determine Intrinsic Value. Earning have to be positive. In addition, negative earnings means that you do not have a workable P/E ratio to use in our formula. That is where fundamental analysis comes in so handy.
It is obvious that RadioShack is going through a rough time and its stock price reflects it. If this continues, in the not so distant future RadioShack is likely to be filling for bankruptcy. Yet, if the company is able to turn itself around and grow again, the stock price will appreciate significantly….providing investors with large gains and very little risk.
Let’s assume that your in depth fundamental analysis has yielded the following points (this is done for valuation explanation purposes and NOT based on the real life analysis of RSH).
- The new and highly experienced management team has taken over operations.
- The new management team has put forth a plan that you believe they will be able to execute.
- Based on your fundamental research you estimate that the company will turn around and earn EPS $0.50 in 2015.
- Thereafter the company will grow at 11% per annum(based on your research).
- After looking at RSH average P/E Ratio and industry averages you feel comfortable with using a P/E ratio of 14.8 for your valuation work.
- Most importantly, based on your work you believe the company will turn around and prosper.
Let’s take a look at the valuation.
STEP#1: Figuring out EPS in 10 years.
- Formula: (Annual EPS x Estimated Growth rate^10)
- RadioShack: $0.50 x 1.11%^10 = $1.42
Explanation: If RadioShack grows its EPS at 11% over the next 10 years (after EPS of $0.50 is acheived), in 2025 its earnings per share will be equal to $1.42
STEP #2: Figuring out stock value at year 10
- Formula (EPS at year 10 x Average P/E Ratio)
- RadioShack: $1.42 x 14.8 = $21.02
Explanation: This means that if EPS and Average P/E ratio holds, the price of RadioShack stock should be $21.02 in the year 2025.
STEP #3: Discounting future value to determine today’s Intrinsic Value
- Formula (Future Stock Value/ WACC^10)
- RadioShack $21.02/(1.07^10)=$21.02/1.9671=$10.72
Explanation: That means the stocks Intrinsic Value today should be is $10.72. With the stock price being $3.35 today, it appears that RadioShack is selling at about 70% discount to its Intrinsic Value.
To be continued…..
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