Valuation Based on Fundamentals
In order to prudently answer the question of when to buy a
stock, an investor first needs to know the value of the company
behind the stock.
At the most basic level, a company derives its value based on
the fundamentals behind the business it operates. Focusing on, and
calculating the fundamental value of a company, lies at the core
that differentiates the investor from the speculator. Investors
want to know what the business is worth, and where its value comes
from past, present and future. Speculators, on the other hand, are
mainly interested in the price of the stock and typically only
concerned with its recent movement.
As we mentioned in part 1 of this series on valuation, Ben
Graham often extolled the virtues of investing over speculating. In
part I of
Common Sense Investing: the papers of Benjamin Graham written
(courtesy of ValueHuntr), Ben started with a discussion entitled
"Investment versus Speculation". The first paragraph summarized his
thoughts on this important matter, and we believe that Ben's basic
ideas hold true today, and are quoted below:
One of the disastrous consequences of the New Era madness
in Wall Street has been the disappearance of the former
clean-cut distinctions between investment and speculation in
common stocks. Old-time investment, with its emphasis on book
value and the past record was shortsighted and naïve, but it
possessed the supreme virtue of moderation. Present day
"investment," as practiced by investment trusts and everyone
else, is not much more than an undisciplined wagering upon the
future and as such logically indistinguishable from
If it's true that a company gets its value based on
fundamentals, and we believe it is, then analyzing and evaluating
the fundamental value of the common stock the investor is
interested in purchasing, should be of paramount importance.
Furthermore, having a sense of how well a company has performed on
an operating basis should provide great insight into the value it
provides to its shareholders.
Unfortunately, most information provided to prospective
investors is, as previously mentioned, focuses almost solely on
price. Therefore, to paraphrase an adage; investors today know the
price of every common stock and the value of none of them.
Calculating the fundamental value of a business has typically
been an arduous and time-consuming task. The investor was required
to pore over complex financial statements and reports in order to
glean the necessary information with which to make an informed
judgment on valuation. Perhaps this is one of the primary reasons
why so few investors have been up to the task. Most sane people
would find this process too tedious and boring to even contemplate,
let alone do. Even though the fundamentals are vital and necessary
in order to make an informed decision, the job is just too
complicated and/or tedious for most people to want to do.
F.A.S.T. Graphs™: Essential Fundamentals at a
The F.A.S.T. Graphs™ research tool was developed in order to
make it easier for prospective investors to ascertain the
fundamental value of a business (common stock) they were interested
in. The F.A.S.T. Graphs™ draw a picture that displays essential
fundamentals at a glance, but they are not meant to be the final
word in the due diligence process. However, they were designed to
provide an insightful perspective of how well a company has
historically been managed, to include how the market has generally
valued the company's operating performance. This powerful research
tool has been programmed to extract the essential fundamentals
behind each publicly traded business and provide an easy to review
graphical interface between price and fundamentals.
Most importantly, the primary focus of this research tool is on
the company's earnings power, and then determining a fair value to
apply to those earnings. Each company's earnings-per-share is
plotted, and the growth rate of those earnings are calculated for
any timeframe the investor chooses to review. This can be as short
as the last two or three years or all the way out to the past
couple of decades. It is recommended that users run various time
periods in order to determine whether growth is accelerating,
decelerating or remaining constant.
The central idea is to determine a fair and reasonable valuation
that can, and should, be applied to each company under review. A
fair valuation, which we call True Worth™, is functionally related
to the rate of change of earnings growth the company achieves. In
part 1 of this series, we focused on low growth companies (0% to
5%) and applied Ben Graham's famous formula in order to calculate
True Worth™. However, for companies that have moderate growth,
which we define as ranging between 5% and 15%, we apply a modified
version of Ben Graham's formula. The following examples look at
several companies and their stock price correlated to earnings
growth through the lens of our F.A.S.T. Graphs™ research tool.
We are going to compare four sets of two companies each that
have very similar fundamentals statistically. Our goal is to
illustrate how statistics alone do not often tell an adequate story
in order to make a learned decision. We're first going to present
the fundamentals only, which will display earnings and dividends.
Then we will overlay stock prices in order to illustrate how stock
prices follow or correlate with earnings over the long run. The
important distinction with these F.A.S.T. Graphs™ is the focus on
fundamentals first and stock price second. This is in contrast to
most stock charts, including ones dealing in technical analysis,
whose primary focus is on stock price and stock price movement.
Our contention is that looking at price alone provides a lot of
information, but no knowledge or wisdom. We believe that true
wisdom occurs when stock prices are viewed in relation to the
fundamental value of the business. Therefore, a perspective of
whether a company is overvalued, fairly valued or undervalued
becomes readily apparent. When information is presented in this
way, we believe the investor can possess the wisdom to make truly
informed, and therefore, sound decisions.
Here is a simple explanation on how to interpret the
following F.A.S.T. Graphs™:
The first F.A.S.T. Graphs™ in each set of two will display
earnings and dividends only. The green shaded area shows earnings,
the light blue shaded area depicts dividends paid out of those
earnings. The orange line represents True Worth™ based on valuing
the earnings under a modified version of Ben Graham's formula that
deals with moderate growth stocks. The earnings growth rate, the
GDF-EDMP (modified Ben Graham formula) PE ratio and the debt to
equity ratio are listed to the right of each graph.
The next set of F.A.S.T. Graphs™ will add two additional, but
very important lines. The black line represents monthly closing
stock prices, and the royal blue line represents the calculated
normal PE ratio that the market has historically applied to the
company's stock price. Included with this set will be the
calculated performance results for each company over the time
period measured (note that there is one year of forecast on these
charts which are not included in the return calculations). The most
important takeaway from these calculated performance results is to
observe how closely capital appreciation (closing annualized ROR)
correlates to earnings growth, adjusted by valuation.
A brief commentary will be provided on each set of graphs for
clarification. However, time and space restraints do not allow us
to provide in-depth analysis on each company. There are two primary
purposes behind this article. First, we illustrate how important
fundamentals are to valuation. Second, our objective is to
illustrate how earnings drive shareholder returns over the long
run. In other words, capital appreciation will equate to earnings
growth adjusted by valuation discrepancies. Also, note how
dividends represent icing on the cake and will add to the total
Stanley Black & Decker vs. Bemis Co. Inc.
An advantage of the F.A.S.T. Graphs™ research tool is to provide
an instant perspective of how well a company has performed on a
fundamental basis over time. Although Stanley Black & Decker
) has grown earnings at a compounded rate of 7.6% per annum since
1992, the road to growth was often bumpy.
click to enlarge images
In contrast, Bemis (
) generated a slightly higher, but similar, earnings growth rate of
8.2% with a lot less cyclicality involved. However, Bemis did
experience some cyclicality over the timeframe 2007 through
When stock prices are overlaid on top of the Stanley Black &
) earnings only graph, we see a strong correlation between price
and earnings. On the other hand, there are several instances where
price gets temporarily disconnected from their earnings justified
value (the orange line) but quickly return. This is a good example
of how overvaluation, fair valuation and undervaluation can be
easily recognized when price and fundamentals are looked at and
The performance results for Stanley Black & Decker (
) clearly illustrate the correlation between earnings growth and
shareholder returns over the long run. Also, even though earnings
growth has been somewhat cyclical, notice how consistently
dividends have grown for this company since 1992.
When looking at the price-earnings correlated F.A.S.T. Graphs™
on Bemis (
) we once again see a strong correlation between price and
earnings. However, we also see that the market has tended to
generally apply a premium valuation to this company's more
consistent record of growth. This is a significant piece of
information that prospective investors can benefit from.
When evaluating the performance associated with Bemis since
1992, we find that the correlation between earnings growth and
shareholder returns is closely correlated. However, we should note
that modest overvaluation in the beginning of the period caused
capital appreciation to fall slightly below the earnings growth
CR Bard Inc. vs. Echo Lab Inc.
The earnings and dividend only F.A.S.T. Graphs™ on CR Bard Inc.
) depict a company that has generated very consistent earnings
growth at an above-average double-digit rate. We also see that the
company has a very low debt to equity ratio of only 6%.
The earnings and dividends only F.A.S.T. Graphs™ on Echolab Inc.
) show that they too have a very consistent record of increasing
earnings at an above-average rate. However, Echolab Inc. (
) does have a higher debt to equity ratio at 30%.
With the earnings and price correlated F.A.S.T. Graphs™ on CR
Baird Inc. (
), you will notice that although the company pays dividends, both
yield and the payout ratio are low. This generally applies to a
company that is still in a strong growth phase, and therefore, in
need of utilizing their capital to fund future growth. We also see
that from 2003 to 2008 the market placed a premium valuation on
their stock, until the great recession caused their price to revert
to the mean. This period of overvaluation is what caused the
historical PE ratio to be so high. This is a vivid example of how
easy it is to recognize overvaluation, and the risk associated with
The calculated performance results associated with the CR Bard
F.A.S.T. Graphs™ above, once again, validates how the rate of
change of earnings growth ultimately drives shareholder returns.
The 10% capital appreciation (closing annualized ROR) is only lower
than the 13% earnings growth due to greater overvaluation at the
beginning than at the end of the timeframe measured. Also, even
though dividends sweeten the pot a little, the majority of CR
Bard's shareholder returns were the result of the market
capitalizing earnings growth.
The earnings and price correlated F.A.S.T. Graphs™ on Ecolab
) tell a very interesting story. For the first five years, 1992 to
1997, Ecolab Inc.'s stock price correlated very closely with their
earnings growth. However, it is not only interesting but also
important to recognize that since 1997, the stock market has placed
a very high premium on Ecolab Inc.'s stock price relative to their
earnings growth. Although we feel that this is irrational, it is
nevertheless an important piece of information for investors to
have. At least with this knowledge, the decision of whether to
invest at such high valuations, or not, can be made with your eyes
It is also very interesting to see how long-term returns have
correlated closely with long-term earnings growth for Ecolab Inc.
shareholders. The calculated performance results shown below
illustrate that Ecolab Inc.'s capital appreciation (closing
annualized ROR) is only moderately higher than earnings growth
because of ending overvaluation.
Target Corp. vs. Sherwin Williams Co.
The earnings and dividends only F.A.S.T. Graphs™ on Target Corp.
) depict a company with above average and mostly consistent
long-term earnings growth. Even though this company's earnings
growth was interrupted during the great recession, 2008 was still
one of the most profitable years that Target Corp. ever had. At a
glance, we see a company with a very strong long-term operating
The earnings and dividends only F.A.S.T. Graphs™ on Sherwin
Williams Co. (SHW) also display a very good long-term record of
earnings growth. However, there are bouts of cyclicality that have
arisen on occasion. Also we can see an earnings drop during the
recession of 2001, and two years of falling earnings during the
housing related great recession of 2008.
The earnings and price correlated F.A.S.T. Graphs™ on Target
) depict a very strong long-term correlation between earnings and
stock price. However, we also can see a lot of inter-year
volatility, especially from 1998 through 2008. It's also
interesting to see that since the great recession, Target Corp.'s
stock price has recovered from excessive undervaluation and now
trades at fair valuation as price currently tracks the orange
earnings justified valuation line.
The calculated performance results for Target Corp. (
) from 1992 to current clearly show that the company's rate of
change of earnings growth translated into similar shareholder
returns. At the end of the day, Target Corp.'s stock price started
out close to fair value and ended up at fair value. Therefore,
Target Corp.'s capital appreciation (closing annualized ROR)
mirrors their achieved earnings growth rate.
The earnings and price correlated F.A.S.T. Graphs™ on Sherwin
Williams Co. (SHW) show that in the long run stock prices track and
follow earnings. Once again, showing how fundamentals drive stock
values over time.
The calculated performance results for Sherwin-Williams Co.
(SHW) illustrate that shareholder returns and operating results are
almost perfectly matched. There will always be short-term
volatility, but in the long-run earnings determine market
Dover Corp. vs. Sigma Aldrich Corp.
The earnings and dividends only F.A.S.T. Graphs™ on Dover Corp.
(DOV) instantly provides a clear insight into this company's
operating results. When the economy is healthy, Dover Corp. has a
history of growing earnings per share very nicely. However, it is
also clear from the F.A.S.T. Graphs™ below that the company's
operating results are very sensitive to recessions. During both the
recessions of 2001 and 2008, Dover Corp.'s earnings experienced a
precipitous drop. On the other hand, as the economy improved,
earnings growth quickly recovers and grows again.
In contrast to Dover Corp., the earnings and dividend only
F.A.S.T. Graphs™ on Sigma-Aldrich Corp. (SIAL) depict a company
with very consistent earnings growth and a great deal of recession
resistance. Although Sigma-Aldrich Corp.'s earnings growth was
slightly lower than Dover Corp.'s, they achieved their growth a lot
more reliably and consistently.
From the earnings and price correlated F.A.S.T. Graphs™ on Dover
Corp., we once again see the strong relationship between earnings
and stock price over time. During both recessions, 2001 and 2008,
Dover Corp.'s stock price followed earnings down. But just like
earnings, stock price recovered as the economy improved.
Once again, when we calculate performance associated with the
F.A.S.T. Graphs™ on Dover Corp. (DOV) we find the strong
relationship between earnings and stock price. The only reason that
both numbers are not exact is based on minor valuation
discrepancies at the beginning and ending periods.
The earnings and price correlated F.A.S.T. Graphs™ on
Sigma-Aldrich Corp. (SIAL) show that the stock market has generally
applied a premium valuation to this company's stock price,
apparently as a reward for its consistent operating results. Once
again, this is an important piece of information for the investor
to have. However, the decision to be willing to pay more for this
company than earnings justify is left up to the perspective
The most important point to be gleaned from the calculated
performance results from the earnings and price correlated F.A.S.T.
Graphs™ on Sigma-Aldrich relates to valuation. Since Sigma-Aldrich
Corp. (SIAL) was overvalued starting out in 1992, long-term
shareholder returns were less than earnings growth. On the other
hand, thanks to their strong and consistent earnings growth,
long-term shareholders still outperformed the S&P 500.
Summary and Conclusions
To us, the evidence is crystal clear, fundamentals provide a
critical perspective that investors should be aware of. Possessing
a clear and accurate picture of how well a business has performed
on an operating basis is a vital component towards making sound and
prudent investment decisions. Contrary to what some might argue,
the fundamental operating results of the business tend to persist.
The nature of a company's business and the industry it operates in
can be reliably evaluated and understood.
There are two quotes from the venerable investor Martin J.
Whitman, chairman of the board, Third Avenue Value Fund that nicely
summarize the main points of this article. The first deals with how
much easier it is to determine the True Worth™ value of a business,
then it is to guess what its stock price might do in the short run,
it is as follows:
I remain impressed with how much easier it is for us, and
everybody else who has modicum of training, to determine what a
business is worth, and what the dynamics of the business might
be, compared with estimating the prices at which a non-arbitrage
security will sell in near-term markets.
" Martin J. Whitman, Chairman of the Board, Third Avenue Value
This second and final quote addresses the notion that
fundamental values are more important than short-term price
volatility. Unfortunately, most people take their guide from price
volatility while almost totally ignoring fundamental valuations. We
believe this is a mistake, and humbly submit that our F.A.S.T.
Graphs™ research tool can greatly assist investors in overcoming
Unrealized Market Depreciation occurs when the market price
of a publicly traded security declines. Permanent impairment of
Capital occurs when the Fundamental values of a business are
dissipated with the consequent long-term adverse
." Martin J. Whitman, Chairman of the Board, Third Avenue Value
As we have stated before, we believe that measuring performance
without simultaneously measuring valuation is a job half done.
Finally, valuation matters a lot, and deserves more attention than
it gets. Wise investors understand this, stand to earn higher
long-term returns at lower levels of real risk.
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours.
The Great Growth Debate (Part 2): The Benefits of
Dividend Growth Stock Investing