In the Stryker forum, Douglas Gerlach wrote:

 

“One of the checks that TK6 does in calculating default judgment is to make sure that the forecast low price is 75% - 80% of the current price.”

 

If you can construct such a check for TK6’s automatic judgment, I suggest that you also build in a similar check for the on-line version of Take Stock.

 

What do you think?

 

Armin

Hi Armin,

And thanks, Doug, for bringing me into the conversation.

FWIW, I have never believed in fudging the numbers (lowering the low price) in order to make the upside downside (risk index) look better. I have always preferred to use the product of the low PE and the trailing twelve months’ earnings to establish the low price (save when the Yield Supporte Low Price exceeds the Low Price calculated in that fashion).

My rationale is that there is always a possibility that, under extraordinary circumstances, a stock will sell for anywhere down to zero. But I'm not doing a stock study to find out the return and risk under such circumstances. I'm doing it to assess what the probably range will be, given a reasonably stable market.

We have learned, after all, that we should never sell a stock because of the price, especially on the down side. In fact, if the company is performing reasonably well, we should consider buying more under such circumstances. Therefore, I don't feel I get any benefit from seeing what I would lose should we encounter a market like the one we're in now. That has nothing to do with my anticipated return (or risk). And I certainly don't see any reason to calculate the risk should my personal circumstances require that I sell the stock when the price is depressed for reasons other than the company's stumbling.

For that reason, the Risk Index or Upside Downside Ratio is of greater value to me when I'm consistent with my calculation of the low price. It, along with the HVR or RV, then serves as an alarm system to warn me if, in the case of the former, my own evaluation of the value of the company is significantly higher than the herd's, or in the case of the latter, the herd's evaluation of the company is lower than its own history of the value (expressed as a multiple of earnings, of course). In either case; i.e., an extraordinarily low Risk Index (U/D Ratio) and/or HVR (RV) tells me that I should re-evaluate the quality issues to be sure that the herd doesn't know something that I don't know.

I submit that the judgmental reduction of the low price, or the failure to eliminate historical outliers in the PE, diminishes or completely discards the value of the Risk Index and HVR respectively. So I don't do it.

Since most of our gurus prefer to look for some rule of thumb to use to reduce the low price when the U/D ratio is low or sub-zero, I realize I'm taking a somewhat lonely position. But I'm happy with it. And I certainly don't support having such an automatic feature in the default judgment process because, not only do you lose the value of the RI (U/D), but you aren't even aware that you've done so. So you lose all of the benefit of those metrics.

ET

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Hey Armin,

 

This discussion ties into an earlier thread on PE levels, and how to predict future levels.  I have always done studies where I made my Estimated low Price below the severe yearly low price. I have also adjusted my low PE as part of the product.

If you look at FDS, the recent market severe low Price is $34.94. 85% of that price is $29.76. With earnings of $2.48 for the TTM, the low PE is 12. (The all time low PE for the stock is 14.1) By using a low PE of 12, I am acknowledging that there is still some downside risk to the stock.

 

If you agree that 12 is a reasonable low PE for the stock (because it gives an estimated low Price that is 85% below the recent severe low Price), what would you use for the average PE? Do you feel that using the average PEG value the stock has traded at in the past worthwhile? That would relate the PE of the stock to it’s earnings growth, which seems somewhat more objective.  

 

For the past 5 and 8 years, the PEG for FDS has averaged 1.3.

Year

01

02

03

04

05

06

07

08

EPS Gr

28%

20%

25%

20%

21%

13%

36%

17%

PE

36

27

23

25

24

26

27

24

PEG

1.5

1.35

.92

1.25

1.14

2.0

.75

1.4

 

If you agree that 1.3 seems like a reliable PEG for the stock, does it make sense to predict future PE based on that? From my SSG, I have predicted annual EPS growth of 12.3%. With an average PEG of 1.3, my future average PE will be 16. (PE/G=PEG; PE/12.3=1.3; PE=12.3 X 1.3=16) If you feel that earnings growth will be greater, the PE will rise also. (That makes sense-stocks tend to sell at a higher PE if earnings growth is high.)

 

I have assigned a low PE of 12 to get the Estimated low Pr that is 85% of the recent severe low. I have assigned an average PE based on the average PEG times my predicted future earnings growth from the SSG. In order for my average PE to equal 16, I will need to assign the high PE a value of 20.

 

I realize that are many other factors that influence a stock PE; Steve Phillips offered a very complete list in a discussion on PE values in 4-08. Establishing a low PE based on the recent severe low price, and an average PE based on average PEG levels seems more objective to me and helps avoid irrational choices.  What do you think?

 

Pat Landers