Evaluating Risk Using the Model's Current and Projected P/E Ratios
In James Glassman's column "Why Low Risk Often Means High Returns," (Washington Post Business Section, August 4, 1996), the concept of estimating risk using p/e ratios is convincingly presented, i.e., high p/e's are more risky than low p/e's (particularly p/e's greater than 20).
The Value Point Analysis (VPA) model, in its "Results" report, gives the current and projected p/e ratios. The projected p/e ratio is simply the Value Point price divided by the projected earnings. Using these two ratios to define a third ratio, the Relative Risk Factor (RRF), it is possible to get an insight into a stock's risk. The RRF is defined as the ratio of the projected p/e to the current p/e. A RRF greater than one, (the proj. p/e is greater than the curr. p/e), indicates that the stock's calculated Value Point (VP) price with its associated input assumptions and projected p/e are relatively more risky than its current price. The current price of the stock in an absolute sense, can still be very risky if it has a high current p/e ratio. Conversely, a RRF less than one indicates that the relative riskiness of the stock's calculated VP price and its associated input assumptions are less risky than its current price. However, the absolute risk of the VP price can still be high if its projected p/e is high.
Thus, the RRF as a measure of relative risk, is primarily an indicator of the riskiness of the input assumptions used in calculating the Value Point price. Stocks that have Value Points with reasonable low risk input assumptions usually have RRF's that are less than, or not much greater than one.
Stocks that have Value Points indicating good current price growth potential with reasonable risk characteristics should satisfy the following three criteria:
1- The VP/Curr.Pr. ratio should obviously be greater than one.
2- The RRF ratio should be less than, or not much greater than one.
3- The stock's current p/e ratio should reflect a value that is consistent with a reasonable projected average earnings rate of growth.
Note, that a zero RRF indicates that one or both p/e ratios have zero or negative earnings and therefore, is not applicable.