Does this method guarantee success and nothing will go wrong if I follow this method ? Ofcourse NO !
Just to re-enforce my stand point in Personal Finance is that one should setup an automated saving system and that would be THE ONLY thing I do NOT give way ... so far. All others are just methods to increase chances of higher return, and all methods are to be fine tuned whenever needed.
Back to this stock valuation method. The real Fundamental about business valuation is its management. ( A good management can turn a lousy business into a good one vice versa.) This stock valuation method is only a quantifiable way to analyse if the management has done good in the past. Its ok if the management has been changing a few times in the past but if the management has changed drastically at the time you are analysing the old data, then you cannot be sure what you are analysing may happen again. In that case, qualitative accessment may need to come first before you perform this quantitative valuation using EPS and PE.
Basically what this stock valuation method does is to take away most of the variables and narrow down to 2 only : EPS and PE. So if you use the right EPS and PE, then you will get the Right assessment.
However, if you really understand what these 2 numbers mean, there is no such thing as Right EPS and PE ! Therefore using the best figures still go back to the art of finding best matched answers. Anyway, this is how I determine what EPS I use during stock valuation. You may use it as reference either way.
1. I first plot down all the past year EPS data into a graph2. then I find out a linear trend of that graph3. then I find two years' EPS that can best match the linear trend
For example, the blue dotted line below is the EPS graph for KNM. The straight solid black line is the trend line. I find that year 2006 EPS exactly fall on the trend line so I will use 2006 EPS. At the other end, the trend line cross the EPS graph between 2000 and 2001 so you may use either one of them. I want to be conservative at recession time like this so I use 2000 which will show a slower growth - which is what I would expect the company to be at time like this - slower growth.
After a while, I still think EPS growth rate from year 2000 to 2006 may or may not be able to repeat in 2008 to 2014. So I further assess the situation more conservatively assuming worse growth so I use 1999 to 2004 EPS.
Basically I have made 2 projection base on what I want to feel more comfortable about, in this case all I want is to be more conservative and play safe in today's situation.
My 1st assessment is what I normally do so that is what I hope to happen. My 2nd assessment is my worst case scenario taking into consideration of my expectation they will not be able to grow as much as they did before but yet strong enough to continue growing. So if both assessments give me positive results then I would be able to consider further to own this business.
An example of using the wrong EPS would be using 2004 to 2007 EPS to calculate future growth for 2009-2012 which I think is a bit over optimist.
Hope this helps a bit on question like which EPS to use ...