Our friend asks us, how do you know if you are paying too much for a stock?
The valuation of stocks can be done in different ways, some faster than others. The usefulness of a valuation lies in helping to determine whether the market price is attractive.
Before we begin, let’s clarify that the market price of a stock is… whatever those who buy it want it to be[1]! In fact, it may be close or far from its fundamental value. Much higher if the buyers think that things are going to get much better (market euphoria) and much lower if they think they are going to get worse (market depression).
To arrive at the fundamental value of a stock, it is necessary to start by valuing the company that issues it.
The most rigorous way requires making a medium- to long-term projection of free cash flows. Free cash flows are the residue after subtracting costs, expenses, taxes, and capital investments from revenues. If we discount these free cash flows to their present value, using a rate that reflects the return expectations of creditors and shareholders, we can estimate the value of the company. If we subtract the market value of the debt from this value, we will find the value of the shareholders’ equity. If we divide this by the number of shares issued, we will find the value per share. This is the value that we must compare with the market price of the stock.
Obviously, to make this type of valuation it is necessary to have a good knowledge of the company and the sector in which it operates, as well as its accounting and the costs of capital that are relevant to it. Thinking about doing this exercise for more than a few stocks, say the five hundred components of the S&P 500 index, can be a very arduous task for the individual investor.
For this reason, there are other types of valuation measures whose calculation is much faster and more practical, although with their limitations, as we will see below.
The most common measure of stock valuation is the P/E ratio, which is the division of the price per share by the earnings per share. Now, what does this ratio tell us?
This ratio tells us the number of times we would be paying for the annual(ized) earnings per share or, in other words, the number of years to recover the investment. If we flip the formula, we would get the annual return on investment. Let’s use an example. The stock is trading at $20 and net earnings per share are $1. The quotient would be 20 times. We would need 20 years to recover the investment, and the inverse would be 5%. Is 5% reasonable? That will depend on several things: how safe, stable or predictable are these earnings? Could I find a similar company at a better valuation? How much do I get on a low-risk investment, and does that return premium offset the additional risk?
A refinement of this measure is to change the denominator to the projected earnings for the next year, that is, not looking backwards (using actual figures) but forwards (using estimated figures). This measure is called the Forward P/E ratio. It can be argued that it is better because it considers a little of the future, however, it uses an estimate and not an actual value.
Some people consider this ratio to be incomplete because it does not consider the fact that in some companies profits are increasing while in others it is relatively stable[2]. For this reason, there is an alternative measure that considers earnings’ growth: the growth-adjusted price-earnings ratio or PEG.
The PEG requires first calculating the P/E and then dividing it by the projected earnings growth. The projected growth is, again, a short- or medium-term estimate. The rule of thumb says that if the PEG is greater than 1[3], the stock is overvalued and vice versa. Stocks with higher earnings growth would justify a higher ratio and vice versa.
A major criticism of these price-to-earnings ratios[4] is the fact of using an accounting measure such as earnings per share. It is known that companies can manage their accounting profit by making use of provisions that are perfectly reasonable from the point of view of accounting rules, but questionable from a fundamental point of view. As an example, we will mention the accounting treatment of depreciation.
For these reasons, some analysts prefer measures less subject to accounting decisions, such as the ratio of price to earnings before interest, taxes, depreciation and amortization[5] (P/EBITDA), or the value of the whole company before such operating earnings (EV/EBITDA). These measures are seeking to insulate the valuation from most accounting and capital structure decisions.
Stock valuation is art and science, but it still pays to always know whether you are acquiring a markedly overvalued or undervalued stock or market segment. It is known that valuation has little impact on performance in the short term but acts as a “gravitational force” in the medium and long term.
A competent financial advisor can help the investor determine the current valuation of their existing or planned investments.
Notice: The information provided herein is for educational purposes only. Portfolio Resources Group does not guarantee the accuracy of any tax recommendation, as we do not provide tax or legal advice. Consult a tax professional to ensure that the recommendations are appropriate for your particular situation.
[1] In the case of bonds, and other fixed-income instruments, this effect is less marked, a very low price makes the return visibly high and vice versa.
[2] This measure would make no sense while the company is showing losses. How much is a company that loses money worth? Answer: it can be worth a lot, if the investor believes that it is temporary! In this case, the valuation measure would be revenues growth or number of customers growth, as long as the company is expected to become profitable after reaching a certain scale.
[3] The divisor would be the magnitude of growth, as an example, if the growth were 20%, 20 would be used. A P/E of 20 divided by year-over-year growth of 20 would indicate a PEG of 1.
[4] The same could be said of another measure with accounting biases such as price to book value (P/BV.)
[5] The price-to-cash flow ratio (P/CF) is a somewhat similar approximation.