Learn stock valuation techniques – Pay close attention to the price you pay for a stock and you minimize your speculative risk. Focus instead on investment returns.
Stock Valuation -the basics
The Stock Analysis framework has shown us the process of identifying great companies with share-holder friendly management teams and wide economic moats. But even the most wonderful business is a poor investment if purchased for too high a price. To invest successfully means you need to buy great companies at attractive prices.
Pat Dorsey, Director of Stock Analysis, Morningstar Inc. in his very useful book – The 5 Rules for Successful Stock Investing – lays down the Stock Valuation basics as below. His writings are the primary source for this article.
Impact of Investment Returns vs. Speculative Returns
Over time, the stock market’s returns come from two key components – Investment Return and Speculative Return. As Vanguard founder John Bogle1 has pointed out, the investment return is the appreciation of a stock because of its dividend yield and subsequent earnings growth, whereas the speculative return comes form the impact of changes in the price-to-earnings (P/E) ratio. Over the entire twentieth century, Bogle found that the 10.4 percent average annual return of U.S. equities broke down into 5 percentage points form dividends, 4.8 percentage points from earnings growth, and just 0.6 percentage points from P/E changes. In other words, over a long time span, the impact of investment returns trump the impact of speculative returns.
Investment Return Vs. Speculative Return
Paying Up Rarely Pays off
What does all this have to do with picking solid stocks? By paying close attention to the price you pay for a stock, you minimize your speculative risk, which helps maximize your total return. No one knows what a stocks speculative return will be over the next year – or even 10 years- but we can make pretty educated guesses about the investment returns. If you find great companies, value them carefully, and purchase them only at a discount to a reasonable valuation estimate, you’ll be fairly well insulated against the vicissitudes of market emotion.
Careful attention to valuation lessens the risk that something truly unknown- what other investors will pay for our asset in future –will hurt the return of our portfolio. As investors, we can diligently work to identify wonderful businesses, but we can’t predict how other market participants will value stocks, so we shouldn’t try.
Being picky about valuation isn’t fun. It means letting many pitches go by and watching many stocks run –stocks that never met your strict valuation criteria. But when its done properly, disciplined valuation also greatly increases your batting average – the number of stocks you pick that do well versus the number that do poorly – and it also limits the odds of a real blow-up damaging your portfolio.
Using Price multiples wisely
Our first stop in learning how to value stocks is traditional measures such as the price-to-sales (P/S) or price-to-earnings P/E ratios. Although these measures do have some advantages – for example, they are very easy to compute and use – they also have some significant pitfalls that can lead the unwary investor to fuzzy conclusions.
The most basic ratio of all is the P/S ratio, which is the current price of the stock divided by sales per share. The nice thing about the P/S ratio is that sales are typically cleaner than reported earnings because companies that use accounting tricks usually seek to boost earnings. I addition sales are not as volatile as earnings –one time charges can depress earnings temporarily, and the bottom line of economically cyclical companies can vary significantly from year to year.
This relative smoothness of sales makes the P/S ratio useful for quickly valuing companies with highly variable earnings, by comparing the current P/S ratio with historical P/S ratios.
However the P/S ratio has one big flaw. Sales may be worth a little or a lot, depending on a company’s profitability. If a company is posting billions , but it is losing money on every transaction, we would have a hard time pinning an appropriate P/S ratio, because we have no idea what level (if any) profits the company will generate.
Therefore, although the P/S ratio might be useful if you are looking at a firm with highly variable earnings –because you can compare today’s P/S with a historical P/S ratio – it’s not something you want to rely on very much. In particular don’t compare companies in different industries on a price-to-sales basis, unless the two industries have very similar levels of profitability.
Another common valuation measure is price-to-book (P/B), which compares a stock’s market value with the book value ( also known as shareholder’s equity or net worth) on the company’s most recent balance sheet. The idea here is that future earnings or cash flows are ephemeral, and all we can really count on is the net value of a firm’s tangible assets in the here-and-now. Legendary value investor Benjamin Graham, one of Warren Buffet’s mentors, was a big advocate of book value and P/B in valuing stocks.
Although P/B still has some utility today, the world has changed since Ben Graham’s day. When the market was dominated by capital-intensive firms that owned factories, land, rail track, and inventory –all of which had some objective tangible worth – it made sense to value firms based on their accounting book value. But now many companies are creating wealth through intangible assets such as processes, brand names, and databases most of which are not directly included in book value.
For service firms in particular P/B has little meaning. If you used P/B to value eBay, for example, you wouldn’t be according a shred of worth to the firm’s dominant market position, which is the single biggest factor that has made the firm so successful. Price-to-book may also lead you astray for a manufacturing firm such as 3M, which derives much of its value form its brand name and innovative products, not from the size of its factories or the quantity of its inventory.
Another item to be wary of when using P/B to value stocks is goodwill, which can inflate book value to the point that even the most expensive firm looks like a value. When one company buys another, the difference between the target firm’s tangible book value and the purchase price is called goodwill, and its supposed to represent the value of all the intangible assets –smart employees, strong customer relationships, efficient internal processes –that made the target firm worth buying. Be highly skeptical of firms for which goodwill makes up a sizeable portion of their book value.
Price-to-book is also tied to Return on Equity (RoE) (equal to net income divided by book value) in the same way that price-to-sales is tied to net margin (equal to net income divided by sales) . Given two companies that are otherwise equal, the one with a higher ROE will have a higher P/B ratio. The reason is clear – the firm that can compound book equity at a much higher rate is worth far more because book value will increase more quickly.
Therefore when you are looking at P/B, make sure you relate it to ROE. A firm with low P/B relative to its peers or to the market and a high ROE might be a potential bargain, but you will want to do some digging before making that assessment based solely on the P/B.
Although P/B isn’t very useful for service firms, its very good for valuing financial services firms because most financial firms have considerable liquid assets on their balance sheets. The nice thing about financial firms is that many of the assets included in their book value are marked-to-market –in other words they are revalued every quarter to reflect shifts in the marketplace, which means that book value is reasonably current. (A factory or a piece of land by contrast, is recorded on the balance sheet at whatever value the firm paid for it, which is often very different form the asset’s current value). As long as you make sure that the firm does not have a large number of bad loans on its books, P/B can be a solid way to screen for undervalued financial firms.
Now we come to the most popular valuation ratio, which can take you pretty far as long as you are aware of its limitations. The nice thing about P/E is that accounting earnings are a much better proxy for cash flow than sales, and they are more up-to-date than book value. Moreover earnings per share results (and estimates) are easily available from just about any financial data source imaginable, so it’s an easy ratio to calculate.
The easiest way to use a P/E ratio is to compare it to a benchmark, such as another company in the same industry, the entire market, the industry average, or the same company at a different point in time. Each of these approaches has some value, as long as you know the limitations. A company that’s trading at a lower P/E than its industry peers could be a good value, but remember that even firms in the same industry can have very different capital structures, risk levels and growth rates, all of which effect the P/E ratio. All else equal, it makes sense to pay a higher P/E for a firm that’s growing faster, has less debt, and has lower capital re-investment needs.
You can also compare a stocks P/E to the average P/E of the entire market. However the same limitations of industry comparisons apply to this process as well. The stock you are investigating might be growing faster (or slower) than the average stock, or it might be riskier (or less risky). In general, comparing a company’s P/E with industry peers or with the market has some value, but these aren’t approaches that you should rely on to make a final buy or sell decision.
However comparing a stock’s current P/E with its historical P/E ratios can be useful, especially for stable firms that haven’t undergone major shifts in their business. If you see a solid company that’s growing at roughly the same rate with roughly the same business prospects as in the past, but it’s trading at a lower P/E than its long-term average, you should start getting interested. It’s entirely possible that the company’s risk level or business outlook has changed, in which case a lower P/E is warranted, but it’s also possible that the market is simply pricing the shares at an irrationally low level.
This method works generally with more stable, established firms than with young companies with more uncertain business prospects. Firms that are growing rapidly are changing a great deal from year to year, which means their current P/Es are less comparable to their historical P/Es.
Relative P/Es have one huge drawback. A P/E of 12, for example, is neither good nor bad in a vacuum. Using P/E ratios only on a relative basis means that your analysis can be skewed by the benchmark you are using. (peer, industry, market).
So, let’s try to look at the P/E ratio on an absolute level. What factors would cause a firm to deserve a higher P/E ratio? Because risk, growth, and capital needs are all fundamental determinants of a stock’s P/E ratio, higher growth firms should have higher P/E ratios, higher risk firms should have lower P/E ratios, and firms with higher capital needs should have lower P/E ratios. We can see why this is true, intuitively.
Firms that have to shovel in large amounts of capital to generate their earnings run the risk of needing to tap additional funding, either through debt (which increases the risk level of the company) or through additional equity offerings (which may dilute the value of current shareholders’ stake). Either way, its rational to pay less for firms with high reinvestment needs because each dollar of earnings requires more of shareholders’ capital to produce it.
Meanwhile, a firm that’s expected to grow quickly will likely have a larger stream of future cash flows than one that’s growing slowly, so all else equal, it’s rational to pay more for the shares (thus the higher P/E ratio). On the flip side, a firm that’s riskier –maybe it has high debt, maybe it’s highly cyclical, or maybe it’s still developing its first product –has a good chance of having lower future cash flows than we originally expected, so it’s rational to pay less for the stock.
When you are using the P/E ratio, remember that firms with an abundance of free cash flow are likely to have low reinvestment needs, which means that a reasonable P/E ratio will be somewhat higher than for a run-of-the mill company. The same goes for firms with higher growth rates, as long as that growth isn’t being generated using too much risk.
A few other things can distort a P/E ratio. Keep these questions in the back of your mind when looking at P/E ratios, and you’ll be less likely to misuse them.
Has the firm sold a Business or an Asset recently?
If a firm has recently sold off a business or perhaps a stake in another firm, it’s going to have artificially inflated earnings, and thus a lower P/E. Because you don’t want to value the firm base don one-time gains such as this, you need to strip out the proceeds from the sale before calculating the P/E.
Has the firm taken a big charge recently?
If a firm is restructuring or closing down plants, earnings could be artificially depressed, which would push the P/E up. For valuation purposes, its useful to add back the charge to get a sense of the firm’s normalized P/E.
Is the firm cyclical?
Firms that go through boom and bust cycles –commodity companies, auto manufacturers are good examples –require a bit more care. Although you will typically think of a firm with a very low trailing P/E as cheap, this is precisely the wrong time to buy a cyclical firm because it means earnings have been very high in the recent past, which in turn means they are likely to fall off soon.
Does the firm Capitalise or Expense its Cash flow generating assets?
A firm that makes money by inventing new products –drug firms are the classic example- has to expense all of its spending on research and development every year. Arguably, it’s that spending on R&D that’s really creating value for shareholders. Therefore, the firm that expenses assets will have lower earnings –and thus a higher P/E- in any given year than a firm that capitalizes assets. On the other hand, a firm that makes money by building factories and making products gets to spread the expense over many years by depreciating them bit by bit.
Price-to-Earnings Growth (PEG)
The PEG is an offshoot of the P/E ratio that’s calculated by dividing a company’s P/E by its growth rate. The PEG is extremely popular with some investors because it seeks to relate the P/E to a piece of fundamental information – a company’s growth rate. On the surface, this makes sense because a firm that’s growing faster will be worth more in the future, all else equal.
The problem is that risk and growth often go hand in glove. – fast-growing firms tend to be riskier than average. This conflation of risk and growth is why the PEG is so frequently misused. When you use a PEG ratio, you are assuming that all growth is equal, generated with the same amount of capital and the same amount of risk.
But firms that are able to generate growth with less capital should be more valuable, as should firms that take less risk. If you look at a firm that’s expected to grow at 15 percent trading at 15 times earnings, and another one that’s expected to grow at 15 percent trading at 25 times earnings, don’t just plunk your money down on the one with the lower PEG ratio. Look at the capital that needs to be invested to generate the expected growth, as well as the likelihood that those expectations will actually materialize, and you may very well wind up making a different decision.
Say Yes to Yield
In addition to multiple-based measures, you can also use yield-based measures to value stocks.
For example, if we invert the P/E and divide a firm’s earnings per share by its market price, we get an earnings yield. If a stock sells for $20 per share and has $1 in earnings, it has a P/E of 20 (20/1) but an earnings yield of 5% (1/20).
The nice thing about yields, as opposed to P/Es, is that we can compare them with alternative investments such as bonds, to see what kind of a return we can expect from each investment. (The difference is that earnings generally grow over time, whereas bond payments are fixed).
A stock with a P/E of 20 would have an earnings yield of 5 percent which is worse than the current bank FD rate of 8%. A stock with a P/E of 10, however, will have an earnings yield of 10% which is better than the FD rates. Thus I might be induced to take the additional risk.
Another popular yield based measure is the dividend yield. The dividend yield ratio allows investors to compare the latest dividend they received with the current market value of the share as an indicator of the return they are earning on their shares. Note, though, that the current market share price may bear little resemblance to the price that an investor paid for their shares.
Dividend Yield = Latest Annual Dividends per share/Current market price per share
Dividend yield is thus an easy way to compare the relative attractiveness of various dividend-paying stocks. It tells an investor the return he / she can expect by purchasing a stock and can thus be compared with other investments such as bonds, certificates of deposit, etc.
The best yield-based valuation measure is a relatively little-know metric called Cash Return. In many ways it’s actually a more useful tool than the P/E. To calculate cash return, divide free cash flow by enterprise value.
Cash Return = Free Cash Flow/Enterprise Value = Free Cash Flow/(Market Cap + debt – Cash)
The goal of Cash Return is to measure how efficiently the business is using its capital –both equity and debt-to generate free cash flow. Essentially cash return tells you how much free cash flow a company generates as a percentage of how much it would cost to buy the whole shebang, including the debt burden. Cash Return is a great first step to finding cash cows trading at reasonable prices.
This brings us to the end of our stock valuation basics section-an essential element of any beginners guide to investing.