How Can I Know If My Stocks Are Fairly Valued?

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 ( ), 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).

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.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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