What Is Vitaliy Katsenelson’s Absolute PE Model About?

Vitaliy Katsenelson’s Absolute PE Model is derived from his book Active Value Investing. In it, he lays out a simply framework as well as a valuation method which he calls the absolute PE model.

We usually us PE ratio as a relative valuation by comparing it to the peers and industry. Vitaliy Katsenelson’s Absolute PE Model aim to derive an absolute PE for the stocks based on several criteria listed below. This model is available in the stock analyzer as an alternative to simply relying on relative valuations.

This model derives the intrinsic value of a stock based on the following five conditions.

1. Earnings growth rate
2. Dividend yield
3. Business risk
4. Financial risk
5. Earnings visibility

Like all valuation models, there is subjectivity involved.

In this case, you are required to grasp an understanding of the business and then quantity the level of risk involved.

You have to decide whether the business risk is low or high and assign a premium value to it or give it a discount.

It’s confusing at the moment, right? But you’ll get it by the end of this article.

 

Core Principles of the Absolute P/E Model to Understand First

Since this model is based on the workings of the 5 conditions mentioned above, it’s important to understand the big picture for each condition.

Instead of just trying to get the formula and start working on it, it’s more important for you to understand the principal behind it. The analyzer will take care of the calculation for you.

 

Principal #1: Assigning a No Growth PE as a Start & Understand the Earnings Growth and PE Relationship

First we will start with a base PE. To do that, you will need to answer this question – What PE you will give a stock that has no growth?

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 . Jea Jun from oldschoolvalue uses PE of 7 (14.2%). In general practise, for a small caps use 7 (14.2%) while big cap use 8.5 (11.8%). For bigger cap stock and stable stock, the market usually are willing to pay a higher PE.

Stock valuation is subjective and all depends on your interpretation. If you have a good thesis on why you are using a certain number, that is 100% ok.

We have determined the no growth PE, but company do have some growth. Logically, higher growth rates leads to a higher PE.

The absolute PE model is set up so that for every percentage of earnings growth from 0% to 16%, the PE increases by 0.65 points instead of 1 point.

If the growth rate reaches a certain level, in this case 17%, the PE value is increased by 0.5 points.

The reason for this is because you’ve witnessed many times that the higher the growth rate, the greater the fall from the top.

Refer to the table below to better understand the relationship between the stock’s PE and the expected EPS growth rate in the Absolute PE model.

The “Original P/E” column is what Katsenelson uses in the book. The “P/E” column the adjusted number based on no growth PE of 7.

From the table we can see that the higher the growth of the stock, a higher PE will be given.

Principal #2: The Value of Dividends

Dividends are tangible to the investor whereas earnings is not.

Dividends provide you with a hard return whereas you may never get to see earnings.

For this reason, a stock that gives dividends gets extra points.

In the valuation model, every percentage of a dividend yield equals one extra point.

This contrasts the non linear relationship between earnings growth and PE as shown in the table above. The right side of the table shows how the points work for dividend paying stocks.

If the dividend yield is below 1%, the bonus point is 0.5. If the dividend yield 5%, the bonus point is 5.

 

Principal #3. #4 & #5: PE Factors for Business & Financial Risk and Earnings Visibility

Up to this principal 2, points are awarded based on the 2 main factors – earning growth and dividend yield. Next, depending on the type of company, a premium or a discount is applied in the actual valuation stage.

What this means is that a stock may get extra points for having a better earnings stability and predictability.

For business risk, you want to consider the industry the company is in, the products, the life cycle, concentration of products and customers, environmental risks and anything else related to the operations of the business.

The level of financial risk can be determined by examining the capital structure of the business as well as the strength of the cash flow in relation to debt and interest payments.

Earnings visibility is analyzed in much the same way.

Below are the risk points to use in the model.

For an average company, you will want to assign a value of 1.

For a market leader, select a number less than 1. If you believe a market leader deserves a 10% premium, then use a value of 0.9. If a 15% premium is deserved, then 0.85 is the number to use.

For a market lagger, select a number greater than 1. Poor companies should be discounted. A 20% discount means a value of 1.2 will be used. Use 1.1 to penalize a stock by 10%.

Based on the business risk, financial risk and earnings visibility, additional PE points are added to the basic PE.

For example if a company is expected to have 10% earnings growth with 0% dividend yield, according to the table above, I would assign it a PE of 13.5. Now, depending on how good the company is, additional PE points are added based on business risk, financial risk and earnings visibility.

Katsenelson writes that he limits the premium to the basic PE to be no more than 30%.

In other words, if the basic PE is 13.5, despite how good the company is, the final adjusted PE won’t be more than 17.55 (13.5 x 1.3=17.55).

If the basic PE is 10, then the ceiling will be limited to PE 13 (10 x 1.3 = 13).

 

Putting the Absolute PE Model Together.

Now let’s put everything together.

The formula to calculate the intrinsic value using the absolute PE method is as follows:

Fair Value PE =

Basic PE

x [1 + (1 – Business Risk)]

x [1 + (1 – Financial Risk)]

x [1 + (1 – Earnings Visibility)]

To get the Basic PE, you start with the no growth PE, put in extra point for earning growth and any any extra dividend points.

Let’s perform the absolute PE valuation for PADINI.

All the parameter are set to default.

For PADINI, the no growth PE is set to 8. Earning is expected to growth at 13.4% based on the calculation from “Growth Rate” tab and the dividend yield of 2.20%.

Earning growth gave an addition 8.71 points to the no growth PE and dividend yield gave an additional 2 point.

The adjusted base PE is 18.71.

Now, depending on how good the company is, additional PE points are added (or deducted) based on business risk, financial risk and earnings visibility.

For business risk, financial risk and earnings visibility, Jea Jun had come out with a systemized and automatic method to do the scoring. Our analyzer has adapted his method of scoring. Nevertheless, you can always change it to your likings.

Numbers from the past 5 years and TTM is used to give a certain number of points to each criteria.

This one is to determine business risk where we look at the trends of ROE, ROA, CROIC and intangibles as a percentage of book value.

PADINI gets a 16/20 which is considered good. The stock gets a premium factor of 6% in the fair value calculation.

To quantify financial risk, we look at the current ratio, total debt to equity ratio, short term debt to equity ratio and FCF to total debt.

Here PADINI scores a perfect 20/20 which is the max premium score with a bonus of 10%.

Trying to quantify earnings visibility is much more difficult, so we’ve tried to keep it as simple as possible by looking at gross margin, net margin, earnings and cash from operations.

A score of 9/20 means earnings predictability is only average which receives a penalty of 2%.

When you apply all this into the formula above the fair value PE becomes 21.38.

The intrinsic value for a PE of 21.38 with current EPS of 0.24 is RM 5.163.

Currently the stock is trading at RM 5.16 with is exactly the valuation by Vitaliy Katsenelson’s Absolute PE Model.

 

Summing Up: A Valuation Model You Should Add to Your Toolbox

Every company is unique and you can’t and shouldn’t use a DCF for every stock.

It’s easy to start plugging in numbers into a spreadsheet and believing what the numbers tell you. But what you should really have a bunch of valuation models that you can go to and pick the one that is applicable for that stock.

The Absolute PE model shows that it works well for stocks like PADINI but it may not be suitable in other stock.

What the Absolute PE method will help you with is to apply a method that uses stock multiples in a much more isolated manner. Instead of just focusing on the competitor multiples and trying to fit your stock to their standards, you can take a step back and use it in an absolute sense.

TRV Stock Analyzer has made this valuation available easily for you. Instead of working on the complicated calculation, you can spend the time thinking about the input for the valuation. The model does have subjectivity and the results will end up being only as good as the inputs, but it’s a technique that is easy to learn and apply.