While it feels way too complicated to a majority, determining a target P/E multiple for a stock isn’t any rocket science. I use a simple formula and some basic judgments in this regard. Having said that, remember that valuation is an art, not a science, so your approach can differ from mine.
There is a Gordon Growth Formula, which determines a target P/E ratio for a constant or sustainable growth model.
P/E = (Payout Ratio) / (R – G)
Payout ratio = dividend per share / earning per share
R = cost of equity
G = sustainable growth rate
For companies with a strong cash flow generation model, such as fertilizers or autos, I assume a 100% payout ratio as otherwise they would be reinvesting in growth.
Cost of equity has different calculation methods; I use risk free bond yield plus risk premium approach. Equity risk premium is additional return that an investor requires in order to take on the additional risk of equities. I use 10% as a risk premium; you can use a different number depending upon your risk profile.
Regarding the risk-free yield part, there are two ways. 1) look at long term yield to avoid short term fluctuations, and 2) use short term benchmarks to keep current monetary policy in mind. Current 10-year PIB yield is hovering around 14% whereas 12-month TBill is trading around 18%. Being conservative, I use 18% + 10% = 28% as the current cost of equity (R).
For growth rate (G), I use nominal GDP growth as the benchmark. 10% inflation + 2.5% real GDP growth = 12.5% earnings growth.
Target P/E = 1 / (28.0% – 12.5%) = 6.5x
This is my benchmark P/E multiple for sound cash flow generating companies. However, there are generally two considerations, which may require some additional work. 1) Above or below short-term earnings growth, and 2) cash flow constraints.
If a company is likely to experience supernormal growth for the next 2-3 years, I will apply 6.5x multiple to fourth year earnings (i.e. when it enters normal growth period) and discount it using the cost of equity. On the other hand, for companies that are unable to generate cash flows in line with their profitability, I use a discount depending upon the intensity of the problem. For example, I use a 50% discount for PSO.
Nevertheless, assigning a target P/E is the last step in your valuation process. Forming earnings outlook is a much more critical and time-consuming process, which I will try to take up next time