Taking the stock’s historical valuation into consideration
Sometimes we see stocks compared with others in the same industry to determine if they are cheap or expensive. This is not a good method. Some stocks perpetually trade at a higher valuation than other stocks for valid reasons and it is more important to look at a stock’s own historical valuation.
When you screen for cheap stocks by any valuation indicator, it is not the absolute level that is the most important. For example, a stock that currently trades at 15x PE is expensive if the stock historically traded at a range of 10x to 15x PE but cheap if the stock historically traded at a range of 15x to 20x PE. Therefore, screening for stocks that are say less than 15x absolute PE is not very useful.
Using a sufficiently long history
The stock market goes through cycles. The valuation of stocks in the last five years would be higher than the valuation of stocks in the previous five years as that period included the global financial crisis. Not going far back enough to take into account various market cycles will cause us to either overvalue or undervalue stocks.
In the chart below you could see that the average PE of the stock 3M Company for the five years to 2019 is 19.7x. If the stock were to trade at 19.5x you would think that it is not expensive. However, if one goes to the previous 5-year period, the average valuation during that period was only 14.4x. Based on that, a valuation of 19.5x would be rather expensive.
To overcome this problem, we should go back more than 20 years so that we can find the true average valuation, which takes into account extreme market cycles such as the dot.com bubble and global financial crisis. It is only by knowing the extreme “highs” and “lows” that one is able to determine the true “normal”.
Taking the stock’s fundamentals into consideration
Different stocks justify different valuations because of its fundamentals. Companies with higher future growth rates will command PE ratios that are higher than companies with low growth. The high growth companies of today will experience a slowdown in growth rates. If earnings growth for the company slows down, we should not expect the company to continue to trade at such high PE.
If a company has a high profit margin, investors should be 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. Therefore, screening for stocks that fall below a certain Price to Sales ratio regardless of the different companies’ profit margins is not meaningful.
Likewise, it can be proven mathematically that Price to Book ratio is related to the company’s Return on Equity. Therefore, different companies with different ROEs deserve to trade at different Price to Book ratios.
Verifying a valuation indicator’s explanatory power before using it
Take Ameriprise Financial for example. It is a financial services company. PE explains this stock well with stock prices trading close to its average PE.
However, Price to Sales ratio does a bad job in explaining stock prices.
And so does Price to Book ratio.
If an investor had selected Price to Sales or Price to Book to decide whether or not the stock of Ameriprise Financial is expensive without first checking if these two indicators are useful, he would have based his decision on the wrong factors.
Relying on a composite indicator rather than stand-alone indicators
When we rely on several standalone indicators, we face several problems. The first is not knowing the decision to take when different indicators give you different conclusions.
For example, this is the valuation of Apple stock as at end 2019 from the same research firm using different methods. Which number do you rely on? Should we not first determine if the stock prices of Apple follow Earnings Power Value, Net Current Asset Value or the various other indicators? If not, how do you decide which one to base our decision on? If we choose Earnings Power Value, it would mean that Apple’s stock is extremely overvalued and if we choose Discounted Cash Flow it would mean that it is extremely undervalued.
When you use standalone indicators, each one may give you a different signal as to whether the stock is undervalued or overvalued. When you use combined rather than standalone indicators, you will not experience this problem because the composite indicator always give you the best correlation with the stock price and it gives you only one conclusion as to whether the stock is overvalued or undervalued. This allows you to effectively screen for undervalued stocks. To find out more, click here.
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