Reference: "How to pick stocks like Warren Buffett" chapter-12.
For instance if you are looking for IBM stock on 8/1/2008 then you would need following information.
- What is the avg P/E ratio ? Let's say it is=15.11
- What is the Earning ? Let's say it is = $8.11
- What is the Earning growth rate ? Let's say it is: 11.21% (reference).
- What is the price today (8/01/2008) ? Let's say it is: $128.00
- What is the dividend (if any) rate ? Let's say for IBM it is 25% of the Earning.
So at this rate, in next 10Y the earning will grow to (using TVM formula) $23.47/year. That makes dividend=$5.87. So total earning = 23.47 + 5.87 = $29.34.
So at current P/E rate the price of the IBM stock will be = (P/E) * (Earning) = 15.11 * 29.34 = $443.29.
On the other hand, for stock to return 15% return on your investment of $128, we need to have (using TVM formula) $ 517.83. So, we have a big gap between what is expected ($517.83) and what can be achieved ($443.29).
If we are going to get $443.29 price after 10Y then to get 15% return the expected price should be: $109.57 (on 8/1/2008). This value will compensate investor from inflation, tax, commission and risk-free return.
Let's take the example of AXP (American Express)...
- 8/1/2008 price: $36.73
- P/E = 12.17
- Earning = $3.02
- Earning growth rate = 12.5%
- Dividend = ~24%
So, after 10Y earning = $9.80 and 10Y dividend=$2.35. Total E=9.80+2.35=$12.15.
So, at current P/E rate, after 10Y the price would be = (P/E) * E = 12.17 * 12.15 = $147.87
Now, at the current price and 15% expected return the 10Y price should be=$148.59. Ideally speaking, to get 15% return today the AXP should be priced at $36.7292, almost what is it right now. Assuming that all above assumptions hold true any price below $36.73 will be attractive to get 15% return.
However, financial market is going through some tough time so probably this price might not compensate for any upward risk in credit market.
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