Identify the drivers of stock price
Different stocks are driven by different financial data.
Example 1: Apple Inc.
Apple Inc. stock is driven by its earnings and well explained by its PE ratio.
Investors don’t buy Apple stock for its dividends and we see no relationship between dividends and share price.
Example 2: General Motors
General Motors stock is not well correlated to its earnings and PE ratio doesn’t explain the stock well.
But it is much better explained by the Price to Cash Flow ratio because the company is cyclical and capital intensive, with earnings that are more distorted by accounting and one-off charges than its underlying cash generation.
Example 3: Deutche Bank
Deutche Bank stock is not driven by earnings because of the earnings volatility.
But its dividends are stable and drives the stock price.
Rather than guess which financial data move the stock price, we allow you to verify visually which are the important ones to focus on for each stock.
Taking the stock’s fundamentals into consideration
Different stocks justify different valuations because of its fundamentals. Companies with high growth rates, good financial condition and good earnings quality (i.e. not suspected of earnings manipulation) will command higher PE ratios.
Price to Sales ratio is affected by a company’s high profit margin. If profit margin is high, investors are willing to pay more for each dollar of sales and therefore it will have a higher Price to Sales ratio than a company with low net profit margin.
Apple Inc.’s Net Profit Margin has expanded through the years.
A higher net profit margin in recent years should result in a higher fair Price to Sales ratio while a lower net profit margin prior to 2020 should command a lower fair Price to Sales ratio. When we do not make this adjustments, stock price looks cheap prior to 2020 as median PE is lifted higher by higher Price to Sales ratio of recent years.
However, once we take into account that fair Price to Sales ratio should be lower when net profit margin is lower, the stock looks fairly valued.
Price to Book ratio is affected by the growth in book value, Return on Equity and the company’s financial condition. When we look at Apple’s stock price vs. its PB ratio, it looks fairly valued if we consider the ROE.
However, if we don’t consider the ROE and simply use the median PB, Apple’s stock looks grossly overvalued.
Median PB fails to capture the huge improvement in Apple’s ROE that warrants a higher fair PB.
Investors are also willing to pay high Price to Cash Flow ratios of the growth of cash flow is strong and the company’s financial condition is good.
Relying on a composite indicator rather than stand-alone indicators
When we rely on multiple valuation indicators, we get multiple valuation.
Different methods give wide ranging valuation. We don’t know which to choose unless we can verify visually which ones the stock price is correlated to. Furthermore, if there are more than one valuation indicator that explains the stock price, we don’t know how best to combine them to give us one conclusion whether the stock is undervalued or overvalued.
Instead of giving you different valuations based on different indicators, we find the best combination of valuation indicators that best explain the stock price. That means you get one fair valuation number to compare against the stock price.
To find out more, click here.
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