From my past posts, we learned how to value a company by reading financial statements and using Warren Buffet’s Equity Bond Theory model. If you are just new to this blog and are not familiar with the model or how to read financial statements, you may read it through here.

Now, there are also easy ways how you can project a stock price for the next couple of years. The results of this principle is best seen in Warren Buffett’s Berkshire Hathaway giant and is one of the few ways I use to determine my stock’s earnings growth potential.

Knowing what your future earnings forecast is vital in pursuing your long-term goals. By understanding it, you can know when to adjust your portfolio by selling some of your “boring” stocks to buy a better investment that offers a better return. And this tool will help you do it easily and wisely.

So here it is;

How To Value A Stock Using The Historical Earnings Growth Model

What does it mean?

The principle is very basic, we just get the historical earnings per share annual compounded growth rate and assume that it continues to increase its earnings per share for the next 10 years at the same growth rate.

How’s it done? Here’s an example on one of my first investments; MEG.

Fig. 1 MEG’s historical EPS,DPS, BVPS and stock price for the last 8 years.

The first thing we have to do is gather the data highlighted in yellow, that is the EPS, DPS, BVPS and the historical price averages for the past 8 years. for the EPS, DPS and BVPS, After we get the required data, we make a spreadsheet file like the one above. Here are the formulas;

P/E Ratio (for high and low) = Stock Price / EPS

%ROE = (EPS / BVPS) * 100

%Payout Ratio = (DPS / EPS) * 100

To get the annual compounded growth rates, we use these formulas;

7-yr. Growth Rate = [(Year 8 / Year 1) ^ (1/7)] – 1

3-yr. Growth Rate = [(Year 8 / Year 5) ^ (1/3)] – 1

After setting up all the data and formula’s, we now get the 7-yr averages.

Fig. 2 MEG’s 7-yr. averages.

The sustainable growth percentage is used in another growth model which I will discuss on my next post. We leave it as is for now.

Now here’s the fun part, computing for the predicted stock price. To do this, we make another spreadsheet like the one below;

Fig. 3 MEG’s historical earnings growth rate chart

We use MEG’s 2014 EPS of 0.66 Php in the current data. To compute for the projected EPS year after year, we use this formula;

EPS = Prev. EPS * (1+annual compound growth rate)

In the example above, the EPS for year 1 is computed as 0.66 * (1+0.236) = 0.82. Year 2 is computed as 0.82 * (1+0.236) = 1.01 To compute for the projected DPS, consider this formula;

DPS = EPS * Payout Ratio

In the above example, the DPS for year 1 is computed as 0.82 * .07 = 0.06. As we can see, on the 10th year, the EPS is now 5.48 Php and the total sum of all the dividends paid is 1.82 Php We now compute for the projected stock price and gain by using the formula below;

Projected price = EPS after 10 yrs. * Ave P/E Ratio

Projected gain = Projected price + Sum of all dividends paid

In the above example, we can see that the predicted stock price of MEG in the next 10 years will be 45.28 Php. That is a whopping 980% gain. If dividends are paid, that would be 1019%.

In my next post, I’ll discuss about another approach that I also use in stock picking, the Sustainable Growth Rate model.

Happy investing!