Take This Valuation Challenge If You Dare

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By Chuck Carnevale :


I believe that having the discipline to only invest in a stock when its valuation is sound is vitally important. Furthermore, there is no better strategy or methodology that prudent investors can embrace to ensure long-term investing success or results at reasonable levels of risk.

But most importantly, assessing the fair valuation of a business can be easily accomplished by anyone. It doesn't require a stratospheric IQ; instead, it is primarily a function of common sense and the application of rather simple and straightforward valuation principles. Furthermore, these common sense valuation principles are universal and apply to anything a person would purchase or shop for.

It doesn't matter if it's a stock, a loaf of bread, a new car, an item of clothing - or anything else. The principle of getting value for your money is the same regardless of what you buy. Every prudent shopper is concerned with getting value for the money they are spending. With this article, I will articulate how getting value for the money you spend applies to investing in common stocks just as it does to anything else you might want to purchase.

Busting Valuation Myths

Fellow Seeking Alpha author David Van Knapp recently penned what I consider an excellent article titled "Why Valuation Matters to Dividend Growth Investors."

The last I checked, he received over 263 comments in what turned out to be a rather lively and, in my opinion, at times controversial discussion about valuation. Many of the comments from various people presented what I consider to be myths regarding valuation as it specifically applies to investing in stocks. Consequently, I was inspired to write this article in order to present a rebuttal against several of the misconceptions that I felt were being presented in the comment thread of Dave's article.

Myth Number 1: Valuation Is a Fleeting Notion

First and foremost was the suggestion that "valuation is a fleeting notion that can only be known completely in hindsight." Now, to be fair, I would have willingly accepted this statement if the person substituted the word "price" for "valuation." However, price and valuation is not the same thing, unfortunately, many people seem to have trouble wrapping their minds around the simple concept.

The price of a stock is certainly fleeting and undeniably volatile. Moreover, the price of a stock doesn't always reflect the intrinsic value of the underlying business. The stock market is an auction, and as such, people are continuously placing "bids" and "asks." This process is very valuable to investors because it is the source of the liquidity that investing in publicly-traded common stocks offers.

However, price is not always a good barometer of intrinsic value. Instead, it is simply a gauge of investor sentiment on a given stock at a specific moment in time. When buyers and sellers connect, a transaction takes place, and a price is temporarily set. However, that price point can change within minutes or seconds as different buyers and sellers engage in additional transactions. Consequently, stock prices are volatile and can, and do, change minute-by-minute, hour-by-hour and day-by-day, etc.

The intrinsic value of the underlying business is an entirely different matter altogether. A business gets its value from the amount of earnings and cash flows it generates on its shareholders' behalf. This production of earnings and cash flows produces fundamental metrics that are identifiable, quantifiable and relevant to valuation. But even more to the point, a company only produces financial statements quarterly; therefore, changes in fundamentals occur a lot less frequently than price movements.

The venerable investor and founder of the Third Avenue Value Fund, Martin J Whitman, put this succinctly and in perspective with the following two quotes:

With this first quote, Marty is telling us that it's easier to evaluate the true worth of a business versus trying to guess where its stock price might go in the short run. With this next quote, he is pointing out the importance of understanding the difference between price volatility and fundamental value:

In order to bring clarity to the distinction between price and valuation, I would like to share my personal approach to determining fair value. While many investors intuitively start out by looking at the price of a common stock they are interested in, price is typically the last thing I look at. Since my strategy is positioning myself as a part owner of the business, my initial step is to evaluate the fundamental strengths or weaknesses of the business behind the stock. To repeat, this is done independent of what the market is currently pricing the stock at.

In order to accomplish this, I utilize the F.A.S.T. Graphs fundamentals analyzer software research tool which I designed with the capacity to remove stock prices from the fundamentals. However, there are many other tools and resources available to investors. Throughout this article, I am going to evaluate Johnson & Johnson ( JNJ ) as my example because this was the company that David Van Knapp utilized in his article referenced above.

The following Johnson & Johnson graph plots earnings and dividends since 1997. The orange line on the graph represents a fair value calculation based on a P/E ratio of 15. On a live graph, I can point to one of the triangles on the graph and a pop-up will appear providing a fair value calculation for Johnson & Johnson based on the P/E ratio. Consequently, my fair value assessment for Johnson & Johnson based on a P/E ratio valuation calculation is approximately $93-100 per share. However, there are many ways to value a business, and the P/E ratio is just one of them. I will talk more about the value of utilizing the P/E ratio as a valuation metric later in this article.

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After I've evaluated fair valuation based on the P/E ratio, I then turn to making a valuation assessment based on cash flows. I believe this is especially relevant when evaluating dividend-paying stocks. On the basis of cash flow, my fair valuation assessment goes from approximately $103 down to $97. This is because estimates for Johnson & Johnson's cash flow for fiscal 2016 are expected to be approximately 5% lower than 2015. Nevertheless, this second assessment of fair value is well within the assessment I made utilizing earnings.

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It is not until after I have established a reasonable range of fair valuation based on the important fundamentals earnings and cash flow that I bring stock price into the equation. Using a round number or a loose average between these two metrics, I have in my mind a fair valuation price for Johnson & Johnson of approximately $100 per share. When I bring price into the equation, I discover that Johnson & Johnson is trading at approximately $118 a share, which is moderately above my initial fair valuation estimates. The following graphs look at Johnson & Johnson's valuation relative to current price based on earnings and then cash flows.

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As previously stated, there are many ways to value a stock (business). When I am evaluating or considering a dividend growth stock, I like to evaluate its current dividend yield relative to historical norms. This next graph adds Johnson & Johnson's historical year-end dividend yields (the burgundy line). With this assessment, the higher the current yield, the lower the valuation. A quick glance at Johnson & Johnson indicates that its current yield of 2.7% is on the low side of historical norms. This gives me a third valuation reference based on dividend yield, and suggests that Johnson & Johnson is not currently at an optimum valuation.

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After looking at valuation based on earnings and cash flows, I turn to FUN Graphs (financial underlying numbers) to examine additional valuation ratios. Johnson & Johnson's current price to book (( PB )) and price to sales (ps) are both towards the high-end of historical norms.

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In addition to examining fundamental valuation ratios, I also like to evaluate the quality or soundness of the underlying business. When I'm looking at a dividend growth stock like Johnson & Johnson, cash flows relative to dividend coverage are critical considerations for me. Therefore, with my next step I again turn to FUN Graphs (financial underlying numbers) and take a deeper look at Johnson & Johnson's various cash flow metrics in relation to their dividend and its coverage. I like to look at several cash flow metrics such as cash flow per share (cflps), operating cash flow per share (ocflps), free cash flow per share (fcflps) and levered free cash flow per share (lfcflps) in relation to dividends paid per share (dvpps). With Johnson & Johnson, I am quite confident that the dividend is safe and well covered.

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There are many other important fundamental metrics that augment my valuation assessment. With this next graph I look at Johnson & Johnson's all-important operating earnings yield (oeyd). I like to see a number above 6 ½% with this metric, but Johnson & Johnson comes in slightly lower at a current earnings yield of only 6.04%. This valuation metric corroborates my assessment that Johnson & Johnson is moderately overvalued.

However, quality and fundamental strengths are also very important, so I also evaluate return on assets (roa), return on equity (roe) and return on invested capital (roi) in my valuation process. Johnson & Johnson scores well on each of these metrics, however, return on assets and equity are a little weaker than historical norms. Nevertheless, I see nothing here that worries me much. This is a high-quality dividend growth stock.

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Since profitability is important to me, I always like to evaluate gross profit margins (gpm) and net profit margins (npm) to get a feeling about the company's profitability potential. Johnson & Johnson scores very well with these metrics, and I really like the consistency I see.

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Up to this point in the article, I have simply demonstrated that there are rational methods available that can be utilized to conduct a reasonable fair valuation assessment of a business. Moreover, I suggest that valuation is not a fleeting notion, but instead a rational measurement of the fundamental strength and attributes of the business under examination.

Although stock prices change often, the fundamentals underpinning a strong business are much more persistent. However, this approach speaks to positioning yourself as a business partner and does not apply to making guesses about stock prices, especially stock price action over the shorter term.

Myth Number 2: The P/E Ratio Gets No Respect - It Should

In David Van Knapp's article he offered the following positioning statement:

He then went on to present that his article was inspired by comments he previously read, the first comment link he included in his article was actually made in an article that I personally authored. The other links come from comments in articles from other authors. However, all these comments were made by the same individual.

However, my purpose for including those excerpts from David's article relates to the inspiration that motivated me to write this article. In the comment thread of David's article, many discussions regarding the relevance, importance, or lack thereof, of the P/E ratio as an important valuation reference were debated. The following represents just one example, which I took as a challenge:

Before I present the requested arguments for why a P/E ratio is a valid, important and very productive investment tool, I would like to put the P/E ratio into perspective. There are many definitions of the P/E ratio. Of course, the simplest is simply price divided by earnings ( P rice/ E arnings). However, this definition is primarily the mathematical formula and it lacks insights into the relevance of the P/E ratio.

However, the following definition of the P/E ratio is my favorite because it provides true insights into the P/E ratio as a valuation tool. This definition states that the P/E ratio tells you how much you are paying to purchase one dollar's worth of a company's earnings. Therefore, if the P/E ratio of a given company is 17, you are paying $17 for every dollar's worth of the company's earnings you bought. If the P/E ratio is 15, then you are paying $15 for every dollar's worth of the company's earnings you purchase.

At this point it's important to recognize that in both of the examples above you are purchasing exactly the same piece of merchandise, i.e., one dollar's worth of the specific company's earnings. So just like it is with buying any identical piece of merchandise, you would obviously rather pay $15 to buy it than $17. When the merchandise is identical in every respect, you always get more value by purchasing it at a lower price (valuation).

When you look at the P/E ratio from this perspective, you quickly begin to understand its relevance as a valuation measurement. Now, I want to be crystal clear about one thing, the examples above are purchasing the same dollars' worth of earnings being produced by the same company. I bring this up because the same value may not apply when purchasing a dollar's worth of earnings for two different companies.

To clarify further, if you are purchasing a dollar's worth of earnings of a company that is growing earnings at a very high rate, let's say 20% per annum, one dollar's worth of their earnings could feasibly be worth more than one dollar's worth of the earnings of a slower growing company. So I want to be emphatically clear, comparing a higher P/E ratio against a lower P/E ratio is most relevant when you are doing it for the same company.

At this point, I would like to address the fallacy that was expressed in the above comment that was posted in David Van Knapp's article. The commenter suggested that purchasing a company at a lower P/E ratio of 17 will have no effect on your goals than had you purchased it at a P/E ratio of 18. Now technically, this statement is categorically false. There will be an effect on your goals, albeit rather small, because there is little difference between a P/E ratio of 17 versus a P/E ratio of 18. However, there is some, and it will have an effect.

Therefore, on the following two graphs I have utilized the performance calculating functionality of the earnings and price correlated F.A.S.T. Graphs on Johnson & Johnson to clearly illustrate the difference. On the first graph, I calculated Johnson & Johnson's performance from January 31, 2007, when the stock was commanding a P/E ratio of 17.6 (this was as close as I could get to a P/E ratio of 18).

Here we discover that a $10,000 investment would have grown to $17,758.91, representing total growth of 77.6 %. Additionally, the original 149.7 shares purchased would have generated an additional $3,367.46 of dividend income. This brings the total to $21,126.37, for a total rate of return of 111.3%, or a total annualized rate of return of 8.1%.

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On the second graph I purchase Johnson & Johnson approximately three months later on April 30, 2007, when its P/E ratio was 16.5 (as close to a P/E ratio of 17 as I can get). Now, there is an important point to consider with this next calculation. The holding period is actually three months shorter, so that should put it at a time disadvantage to the previous calculation.

Nevertheless, had you invested $10,000 in Johnson & Johnson on April 30, 2007, you would have purchased 155.71 shares compared to the 149.7 shares in the first example. Therefore, the additional six shares purchased at the lower P/E ratio somewhat mitigates the disadvantage of the shorter holding period. Therefore, the initial $10,000 investment would have grown to $18,471.88, which is approximately $712 more growth. Likewise, the dividend income would have been $3,441.21, which is approximately $74 more than we saw in the initial example.

The total growth is now 84.7% versus 77.6%, and the total rate of return is 119.1% versus 111.3%. The total of growth plus dividends is $21,913.09, which is approximately $786 more than we saw when we purchased the stock at a higher P/E ratio. This generated a total annualized rate of return of 8.7% versus the 8.1% total annualized rate of return we saw with the first example.

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Some of you may not consider this much, but no one should argue that purchasing the same stock at a lower P/E ratio over a very similar time frame had no effect on results. As David Van Knapp posted in his article, "The income from a stock purchased at a better valuation will always exceed the income you would receive if the stock were purchased at a worse valuation."

With my next example I'm going to utilize price to cash flow (P/CFL) as an additional valuation metric in lieu of the P/E ratio. The principles of valuation apply the same when utilizing cash flow (P/CFL ratio) as it does when utilizing earnings (P/E ratio). However, to more emphatically demonstrate the power of sound valuation, I'm going to compare purchasing Johnson & Johnson at a lower price to cash flow with a two-year disadvantage.

In the first graph, I calculate purchasing Johnson & Johnson on November 30, 2001, at a rather high price to cash flow of 25.3. Then I compare the returns had I waited two years to purchase Johnson & Johnson on November 28, 2003, at a fair value price to cash flow of 15.3.

This example is offered in response to discussions debating the notion that investing in the same company and at a better valuation will always lead to better returns and more income. And it also addresses the argument of whether it is beneficial to wait for the stock to move into fair valuation. I think the examples clearly illustrate the benefit of fair valuation generating more growth and more dividend income.

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Take the Valuation Challenge

In the title of this article, I challenged readers to take the valuation challenge. In order to enable the reader to take this challenge, I offer the following link to a fully functioning F.A.S.T. Graphs to include FUN Graphs on Johnson & Johnson. This is a free preview graph that includes everything that a premium subscriber to F.A.S.T. Graphs would have at their disposal. Consequently, every graph that I produced in this article can be duplicated by the reader by following this link.

Here is my challenge and how it can be accomplished by the reader. On the live graph you can run your mouse along the black monthly closing stock price line and pop-ups will appear listing the date, the stock price and the P/E ratio at that time. You can then double-click any of those points and a red dot and pop-up will appear assuming a $10,000 investment with calculations as to the stock price, how many shares would be purchased and the P/E ratio at that time. You can then move your mouse and point to any other future price on the graph and double-click that spot and a calculation will appear providing all of the performance calculations to include dividends over that time frame.

Therefore, I challenge any reader to show me one example where purchasing the stock at a lower P/E ratio compared to a higher P/E ratio will not produce better total returns and more dividend income if the time frames are within reasonable proximities. You can run thousands of calculations if you choose. The orange line on the graph represents a fair valuation reference and you can run these calculations from high valuations, low valuations or fair valuations. I am confident this exercise will open the reader's eyes to the true value of valuation based on P/E ratios or price to cash flows.

Remember, this is a fully functioning free Johnson & Johnson F.A.S.T. Graphs and you can also go to FUN Graphs and review all of the financial underlying numbers associated with Johnson & Johnson. You can also utilize the various metrics available in the tan navigation bar to the left to review other earnings metrics such as GAAP and, of course, cash flow. My hope is that you learn a great deal about the importance of valuation while simultaneously having some fun.

Here is the link for a FAST and FUN Preview of F.A.S.T Graphs using the stock symbol JNJ

Bonus: a fully functioning F.A.S.T. Graphson CSCO

As an additional bonus, I'm also giving the reader access to a fully functioning set of graphs on Cisco ( CSCO ). This once pure growth stock has recently morphed into an attractive dividend growth stock. Consequently, it provides some different perspectives than what you see with the blue-chip Dividend Aristocrat Johnson & Johnson. I also included this preview because Cisco represents a quintessential example of how crazy and irrational the stock market can be when pricing a stock.

At its peak in March 2000, you would have had to pay more than $161 to buy one dollar's worth of Cisco's earnings. Calculate forward performance (lack thereof) when paying such an extreme valuation. I don't think there's a better example of the importance of valuation coupled with the acknowledgment that the market does not always price stocks correctly.

Here is the link for a FAST and FUN Preview of our F.A.S.T Graphs using the stock symbol CSCO

Summary and Conclusions

Valuation matters to dividend growth investors, and all other investors as well. Facts are more relevant than opinions. I hope you took this challenge and got the facts.

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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.

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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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