Submitted by
Fast
Graphs
as part of our
contributors program
.
Not having the confidence that they know the true worth of their
stocks, is one of the most common laments expressed by many
individual investors. Even more importantly, knowing the price of
all their stocks, but not knowing their value, is often a major
source of shareholder losses. Expressed differently, when you don't
know the value of what you own, it's very easy to be taken
advantage of. It's an undeniable fact, that people are
emotionally attached to their money. Therefore, it's no
wonder that all the price volatility accompanying an often
irrational stock market can be quite unnerving. As a result,
investors often buy when they should sell, and sell when they
should buy.
Making matters even worse is the reality that there is no
precise or absolute calculation of intrinsic value or what we like
to call true worth. This stems from the fluid nature of a business
where future prospects can rapidly change. Think financial
stocks in late 2006, going into 2007 and 2008. Once
apparently very healthy and profitable enterprises, the fortunes of
many financials collapsed with a vengeance. The following
earnings and price correlated
F.A.S.T. Graphs
™
on Citigroup (
C
) provides a vivid portrayal of how quickly a company's prospects
can change. On the other hand, as frightening as this is, it is
very rare to see the fortunes of a company or industry change so
dramatically and as fast as we saw with the financial industry. But
clearly it can happen, which makes a strong case for
diversification.
Perhaps one of the most interesting aspects of the Citigroup
example is that the company's stock price actually correlated to
its intrinsic value based on earnings throughout this 20-year
history. In other words, where earnings went, stock price
followed, and even more importantly, whenever price deviated, over
or under, from fair value (the orange earnings justified valuation
line in the graph), it quickly came back into alignment. But
obviously, although the price adjusting to earnings in 2007 and
2008 was rational, it was horrific at the same time. Nevertheless,
the principles of valuation held true in this example and will be
elaborated on later in this article.
What Is Fair Value and How Can I Calculate It?
As we stated earlier, there is no absolute or perfectly precise
calculation of fair value. However, that does not mean that
attempting to determine fair value is an impossible exercise.
Quite the contrary, the prudent investor can, easier than many
people believe, calculate a reasonable range of fair valuation that
they can use to make sound and smart long-term investing decisions.
The only reason that fair value cannot be calculated with absolute
precision is because part of the calculation must be based on
estimates relating to future time.
Moreover, the rational and intelligent investor recognizes that
although estimates of future fundamentals such as next year's or
next quarter's earnings might not be perfect, they also recognize
that they don't need to be. Instead, future earnings estimates only
need to be good enough to make a decision that is economically
sound. Because, the rational and intelligent investor also
realizes that since Mr. Market often behaves irrationally, that
perfect tops or bottoms are rarely achieved except by chance.
Therefore, instead of seeking perfection, investors must accept a
reasonable range of probabilities that offers a high potential for
success.
But perhaps the most important aspect of fair valuation is that
it is only one component, albeit a very important component, for
determining your long-term potential return from owning a common
stock. The second important component is the rate of change
(growth rate) of the earnings of the respective company you are
analyzing. This leads me to another important refinement that adds
insight to the relevance and importance of valuation. True
worth, intrinsic value or fair value, no matter what you choose to
call it, all refer to the same concept. However, it's important to
understand that fair value is a present time metric, whereas the
earnings growth rate is more applicable to future time.
The notion that fair value is a present time metric is based on
the following, and often misunderstood relevance of fair value, as
it applies to making a sound investing decision. At its core,
the fair value of a common stock relates to what you are paying to
buy a current dollar's worth of the company's earnings. From
this perspective, fair value depicts the current earnings yield
that the investor is receiving on their capital. The most common PE
ratio that depicts fair value for most companies is 15, which
represents a current earnings yield of 6% to 7% (the actual number
is 6.666%, but somehow my Christian upbringing precludes me from
stating so). Put another way, this is more or less the average
earnings yield for the average publicly-traded company.
To clarify even further, let's review two companies through the
lens of F.A.S.T. Graphs ™ where both demand a current fair value PE
of 15, however, each respective company has significantly different
historical earnings growth rates. In both examples, the current
fair value PE ratio of 15 applies regarding making a sound current
investment decision. However, the rate of change of earnings growth
will have a material impact on future earnings power, and
therefore, future long-term return potential.
Our first example will look at Church & Dwight Inc (
CHD
) an above-average growing supplier of household products.
With this fast growing company, we only have to look back to
calendar year 2003 to illustrate fair value as one component of
return versus rate of change of earnings growth as our second
component. At the beginning of 2003, Church & Dwight was
trading at approximately a PE ratio of 15 which calculates our 6%
to 7% fair value earnings yield. In other words, this
represented a sound valuation to pay for this above-average growing
company.
In this example, assuming that we bought the stock in January of
2003, we acquired $.61 worth of earnings at an approximate PE ratio
of 15. This purchase represented our fair value current earnings
yield of 6% to 7% based on the current earnings we purchased.
However, thanks to the power of compounding, and utilizing the Rule
of 72, we are purchasing a stock whose earnings are doubling
approximately every five years. Therefore, although we are
buying current earnings at fair value, we are buying 5-year future
earnings at a bargain PE ratio of approximately 7.5, or half the
cost of our original earnings, thanks to the doubling approximately
every 5 years. Note through the green highlights at the bottom of
the graph that our original $.61 of earnings grew to a $1.27 worth
of earnings by year-end 2007 (in essence a doubling).
With our second example, we look at a slower growing utility
stock, SCANA Corp. (
SCG
) whose historical earnings growth has only averaged 3% per
annum. At this rate of earnings growth, again using the Rule
of 72, it takes approximately 24 years for this company to double
its earnings. Unfortunately, our graphing tool only offers
data going back approximately 21 years to 1993, nevertheless, we
can see that after 21 years, earnings have yet to double. On
the other hand, we see clear evidence that this utility stock has
typically commanded a PE ratio of approximately 15 (the orange line
on the graph represents a PE of 15) for the most part over the past
21 years. Other ways of stating this would include that a PE of 15
is a good buy, and a PE ratio below 15 is a better buy, but
prudence would dictate that you never really want to pay much above
a PE of 15 to buy this utility.
The lesson underpinning this story is that it's important to
only pay fair value for either of these companies on the buy
side. However, keep in mind that fair value is only part of
the return story. Consequently, if you stick to the PE ratio of 15
as a fair value guide for most companies, you can be confident that
you are investing in them at a sound valuation. By doing this you
can then turn your attention to the earnings growth rate in order
to develop a reasonable expectation of future potential returns.
However, keep in mind that these examples have only focused on
capitalizing earnings. Dividends, if any, would need to be
added into your potential return calculations.
The moral of the story is that any time you find a company that
is trading at a PE ratio above 15, you can immediately assume that
an overvaluation situation is probably evident. On the other hand,
there are additional considerations regarding the proper valuation
of a business that come into play. For example, the concept
of risk is an important consideration. There are certain
companies of impeccable quality that have historically enjoyed, and
may even deserve, a premium valuation.
Keep in mind that if you buy a high-quality blue-chip and pay
16, 17 or 18 times earnings, in other words, above our rule of
thumb fair value PE of 15, this simply means that your future
return will be lower than it would have been had you only paid the
PE ratio of 15. But this does not mean that you will lose money,
nor does it mean that you won't receive a reasonable rate of return
on your money. However, it might mean that you will earn a return
that is lower than you deserve, but perhaps a return that is earned
at lower risk.
Procter & Gamble Co. (
PG
) represents a case in point. Historically, this blue-chip
dividend growth stock has commanded a premium PE ratio of
approximately 18 to 20 times earnings. Currently, the company
is trading at a PE ratio of 17.7 which is slightly higher than our
ideal PE of 15, but not excessively so. Especially if you are
willing to accept that this is lower than their historical PE, and
that this blue chip offers a 3.2% above-average dividend yield that
has increased every year for 56 consecutive years. When these
things are considered, paying a slight premium for this blue chip,
although technically above our fair value PE of 15, might actually
make sound and prudent sense.
On the other hand, the wise investor should also realize and
accept that they can expect to earn a lower total return for the
safety and reliability of investing in a blue chip like Procter
& Gamble at a premium valuation. Therefore, let's look to the
future to see what this actually means regarding our potential
future return. The following estimated earnings and return
calculator on Procter & Gamble represents consensus estimated
forward 5-year growth at 6.9%. The 5-year estimated total
return of 6.3% is positive and maybe even reasonable for a company
of this quality with a 3.2% dividend yield that could be expected
to grow by approximately 7% per year.
But here is another twist to the valuation conundrum that also
needs to be considered. Since our future return is a function
of what happens in future time, our decisions can only be made
based on estimates. Consequently, it's also rational to
recognize that estimates may not come to pass as precisely as we
originally anticipated. On the other hand, as it relates to
quality companies with long established records like Procter &
Gamble, we can be pretty confident that our estimates will come in
within a reasonable range of accuracy, more or less.
To illustrate this point, the following forecast (estimated
earnings and return calculator) is based on 21 analysts reporting
to Zacks. Instead of the 6.9% forecast 5-year growth we got
from Capital IQ, the Zacks' analysts forecast Procter & Gamble
to grow at a slightly higher rate of approximately 8%.
Consequently, our theoretically premium (slightly overvalued) PE
ratio of 17.7 would produce a 7.1% compounded annual return
assuming Procter & Gamble trades at a fair value PE of 15 by
year-end 2018, assuming of course that the 8% estimate proves
true.
The point of this exercise is to illustrate that valuation is a
little more subtle and even complex than just saying that a PE of
15 is fair value. Factors such as quality (risk) and future
growth rates are major factors that need to be considered as
well. At the end of the day, we can use these measurements in
order to determine whether or not we feel we have the opportunity
to be adequately compensated for the risks we are taking.
Our next and final example looks at Home Depot (
HD
), a company that appears clearly overvalued based on its
historical earnings growth rate of 7.2% per annum, which justifies
our normal or average PE of 15 valuation. Up until the
beginning of this calendar year, it is clear that the market had
normally priced the company in line with our fair value PE of 15
(the orange line on the graph).
As we turn our attention to the future, the Home Depot valuation
story becomes more interesting. Since calendar year 2003 Home
Depot has, as previously stated, averaged an operating earnings
growth rate of 7.2% per annum. However, the consensus of 30
analysts reporting to Capital IQ, expect Home Depot's future 5-year
growth to average 15% per annum. On that basis, if you could buy
the company at a PE of 15, you should expect capital appreciation
of 15%, plus a percentage point or two of dividend kicker.
However, since Home Depot is currently valued at an overvalued
PE ratio of 21.3, the 5-year estimated total return, including
dividends, drops down to 9.7% per annum. They are two points
here that relate to valuation that are important. First of
all, this future expected rate of return, we should point out, is
higher than what we can rationally expect from Procter & Gamble
with its lower PE ratio, but approximately half the future expected
growth rate.
Second, the real risk in this example in the
short-to-intermediate term relates to the potentiality that share
price could drop into the $40 range over the next two years or so,
which assumes that the company mean reverts to its fair value PE of
15. On the other hand, if this company does in fact grow at 15% per
annum, we will have more than twice as much future earnings ($6.77
versus $2.97) for the market to capitalize. However, the
rational and prudent expectation would be that Home Depot's future
PE mean reverts to 15, which is our rule of thumb fair value
PE.
Summary and Conclusions
Although this article deals with some of the more important
aspects of ascertaining the fair valuation of a common stock, it
should be understood that it only scratches the surface. On
the other hand, we hope that the readers agree that it does
establish some important principles and frameworks that fair value
is based on. There are numerous variations, nuances and
combinations of PE ratios and growth rates that space and time
precluded being made. However, we also hope that we laid a
solid foundation of which greater understanding of valuation could
be built upon.
What was written in this primer on valuation dealt primarily
with companies whose earnings growth rates were less than 15% per
annum. Once earnings growth exceeds 15% per annum, the power
of compounding creates a powerful dynamic that implies PE ratios
greater than 15. With the case of very fast-growing
companies, the current fair value earnings yield of 6% to 7% gives
way to much higher future earnings yields. This is based on
the exponential increase in future earnings that high growth rates,
if achieved, will generate. Furthermore, this also implies
that the higher potential future returns also carry the necessity
of higher risk.
However, when all is said and done, the principle of valuation
is not as complex, esoteric or even as mysterious as many people
believe. Having a grasp of valuation is mostly about applying a
little common sense and an awareness of some simple mathematics.
When the operating results of a business, i.e. its earnings and
cash flows, do not represent an attractive rate of return on
investment, it should be instantly obvious to the prudent investor
that fair valuation is not present. Conversely, when the earnings
yields are very high based on reasonable assumptions, the
opportunities this represents should be readily apparent as
well. So in closing, valuation is not hard, especially if you
have the right tools at your disposal.
Disclosure: Long C, PG & HD at the time of
writing.
Disclaimer:
The opinions in this document are for informational and
educational purposes only and should not be construed as a
recommendation to buy or sell the stocks mentioned or to solicit
transactions or clients. Past performance of the companies
discussed may not continue and the companies may not achieve the
earnings growth as predicted. The information in this document is
believed to be accurate, but under no circumstances should a
person act upon the information contained within. We do not
recommend that anyone act upon any investment information without
first consulting an investment advisor as to the suitability of
such investments for his specific situation.