The following principles are employed to value stocks.
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 last five years is 19.7x. If the stock were to trade at 19.5x today 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 at least 20 years if possible 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”.
Not relying on a valuation indicator until I have verified mathematically or visually that it explains the stock price
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 arbitrarily selected Price to Sales or Price to Book to decide whether or not the stock of Ameriprise Financial is expensive, 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 from the same research firm using different methods. Which number do you rely on? Should you not at least see if visually 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 your decision on, especially if choosing Earnings Power Value would mean that Apple’s stock is extremely overvalued and choosing Discounted Cash Flow would mean that it is extremely undervalued.
Let’s say you have read a book on the Graham Number and believe that the method is logically sound. However, if you were to plot the price of Apple stock vs. its Graham Number, you would see that the correlation is very poor.
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.
Take for example, Royal Caribbean Cruises stock, which is fairly valued based on Price to Earnings ratio.
It is severely overvalued when you look at its Price to Sales ratio.
It is also severely overvalued when you look at its Price to Book ratio.
However, when you combine all the five valuation indicators and choose the best combination that explains the stock price, you end up with only one conclusion on which you can act with confidence.
We see that the stock of Royal Caribbearn is only slightly overvalued when we use the Composite Valuation Indicator. It is therefore worth monitoring to find opportunities to buy at slightly lower values.
Taking the stock’s historical valuation into consideration in deciding whether or not the current valuation is cheap
When you screen for cheap stocks by any valuation, 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. It is more useful to individually determine the stock’s median PE over a long history and compare the stock’s current valuation with its median historical valuation.
This is even more crucial when screening based on some other indicators such as Price to Sales ratio. 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 irregardless 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 and screening based on one number for all companies is not very useful.
Taking the company’s future growth rate into consideration and not just its historical average PE
It can be proven mathematically that companies with higher future growth rates will command Price to Earnings ratios that are much higher than companies with low growth. Therefore, even calculating a separate median PE for each company is insufficient. One needs to further adjust for any slowdown in future growth. The high growth companies of today – like Amazon and Facebook – will experience a slowdown in growth rates. As a company gets bigger, growth will be increasingly more difficult. (See below how revenue growth of Facebook has slowed from near 100% to 20+%, which is still impressive).
We should take the slowdown in growth into consideration when valuing companies that have valuations that are not justified by the expected slowdown.
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