# Strategy Design Cheat Sheet

The Basic Logic

• Starting Point: Stocks should be priced at the present value of expected future cash flows
• Tbis is often impractical due to the extrme and unrealistic forecast burden it presents
• Simpler Formulation: Gordon Dividend Growth Model, P = D/(R – G)
• P = Stock Price
• D = Next Expected Dividend
• R = Required Rate of Return which is based on market interest rates and premiums for assuming (a) the risk of the equity market in general and (b) the unique risks associated with this company
• G = Expected future (infinite) rate of dividend growth
• Practical adaptation to address the reality that dividends are often minor or non-existent; treat all of Earnings as accruing to shareholders with shareholders implicitly choosing to reinvest all or most earnings back into the business. Substituting E (Earnings) for D, we get:
• P = E/(R – G)
• Re-arranging the equation (dividing both sides by E), we get a formula for the ideal P/E
• P/E = 1/(R-G)
• This tells us that as G (growth) rises, P/E should rise
• This also tells us that as R (required return) falls, P/E should rise. Therefore, considering the components of R, we know that as Interest Rates fall, P/E should rise, as equity market risk falls, P/E should rise, and as company-specific risk falls, P/E should rise. Expressing the latter a different way, as Company Quality rises, P/E should rise.
• It’s not practical to work as if this was a specific formula into which we can plug numbers because real-world estimation (especially the notion of infinite growth) is too difficult
• But we can use these ideas as a theoretical roadmap for developing a stock selection strategy
• Favor stocks that show such data characteristics as to justify a credible assumption that V (Value; P/E and/or other valuation ratios) is too low relative to G (expected future growth) and/or Q (company quality)
• Future growth cannot be quantified; instead, use S (Sentiment) as a proxy for the investment community’s broad expectations regarding the future)
• Hence the overall theme of the strategy: a combination of Value, Quality and Sentiment, or VQS

Refinements

1. Looking more closely at R (Required Rate of Return
• Use Capital Asset Pricing Model as a guide
• R = RF + (B * RP)
• RF = Rate of Return on Risk-Free Assets
• RP = Risk Premium investors demand in order to invest in a risky asset class (e.g., equities)
• B = Beta, a measure of company-specific Risk
• Takeaways
• As interest rise, RF rises causing R to rise and, all else being equal, depresses P/E
• As investors become more concerned about the risks associated with equities, RP rises causing R to rise and, , all else being equal, depresses P/E
• As company-specific risk rises, B rises causing R to rise and, , all else being equal, depresses P/E
• Conversely, reductions in RF, RP or B drag R down and, all else being equal, push P/E upward
2. This Framework Encompasses Valuation Ratios Other Than P/E
• Example: Price/Sales
• Earnings = Sales * Margin
• Therefore
• P = E / (R-G) = (S * Margin) / (R – G)
• P/S = Margin / (R – S)
• Hence, higher P/S ratios are justified by lower R, greater G and/or higher margins
• Example: Price/Book
• `Earnings = Return on Equioty, or ROE * Book Value
• Therefore
• P = E / (R – G) = (BV * ROE) / (R – G)
• P/B = ROE / (R – G)
• Hence, higher P/B ratios are justified by lower R, greater G and/or higher ROE
• Other ratios can be similarly adapted. Ultimately, an appropriate ratio between the price of a company (price per share, enterprise value, etc.) and a fundamental measure such as Sales, Margin, EPS, Dividend, EBITDA, Cash Flow, etc. is assessed with respect to
• Expected growth of the fundamental characteristic being considered, and
• Required Rate of Return which comprises interest rates, asset-class risk and company-specific risk.
3. Price Determination Is Not Always Logical
• Up till this point, we’ve assumed that P=V; i.e., that the price of a stock should be equal to its fair value
• This is oversimplified
• We have to account for market “noise”
• Noise, N, is not something dysfunctional we expect to eradicate with better investor education; it’s a normal and inevitable aspect of the market
• Therefore, P = V + N (Price = Value + Noise)
• Generally speaking . . .
• The easier it is for investors to come up with reasonably credible estimations of value, the less room there will likely be for noise to influence the price. Conversely . . .
• The harder it is to come up with a credible, defensible objective valuation, the more room there is for noise to influence price
• One way to quantify Noise as a percent of market capitalization is to use the following formula
• For further information on this topic, see . . .
• Robert J. Shiller, Stock Prices and Social Dynamics, 1984 Brookings Institution Paper
• Charles M.C. Lee, Market Efficiency and Accounting Research, 31 Journal of Accounting and Economics, 233-53 (2001)
• Fischer Black, Noise, Papers and Proceedings of the Forty-Fourth Annual Meeting of the America Finance Association, New York, New York, December 20-30, 1985, Journal of Finance, Vol. 41, Issue 3 (July 1986)