Valuing a good companies stock is easy because with a good company the earnings are stable, the management is there, and you can project going forward what a company will be worth. If the company has poor management it may be difficult.
Some things to look at when classifying a stock as “good” might be “ROA” (return on assets), earnings growth history and a positive quick ratio. This indicates that management is investing in assets and producing a good return, and that management has more assets than liabilities and that management is able to produce earnings growth. Other things such as sales growth are also important as increases in sales sometimes leads to future earnings growth.
Things that determine the quality of the company are listed above, but the value is based on the companies price.
Things like price to sales, price to book, price to earnings, price to earnings growth, and things of this nature.
Relative pricing depends on the companies pricing in it’s industry. For example, if the competitor on average has a P/E of 18 with a PEG of 2 and this company has a P/E of 10 and a PEG of 1 it is undervalued relative to the competitor.Comparisons are good to do especially if you plan on hedging.
Hedging is the act of buying and selling securities in the same industry. If you go long and buy Ford while you sell Toyota, the sale of Toyota hedges your position in Ford because if the auto industry does poorly, you anticipate profiting from betting against Toyota. If it does well, you will benefit from the growth in Ford. The goal of both of these trades (known as a “paired trade”) is to pick overpriced stocks as well as underpriced stocks and buy the underpriced stocks that represent good value with good management, and buy the overvalued companies with poor management. It’s not always easy and may require some time as well as enough cash on the side to manage the position, and this should be done across many, many industries if you want to do this properly. The problem with hedging is that you have to choose between either buing exposed to oneside more than another, or being perfectly hedged prevents you from gaining exposure to the most undervalued companies. Ideally you want to increase allocation to a particular stock if it is overvalued significantly and you are betting against it as well as those that are undervalued significantly. You also would have to endure the possibilities of buy outs on stocks you are betting against, and fraud which is rare but possible, or overnight drops in stocks you are long. That is why if you are hedged you have to spread your funds against a ton of positions so that no one position can negatively impact you. The other option would be to use stock options as a way of hedging.
Just because you can identify a company that is undervalued, does not mean it won’t stay that way for a length of time, or even go down in price and become more undervalued, or possibly some of the facts you have may even be wrong. Perhaps a lawsuit against a company occurs or is pending, or perhaps a company claims to own assets it does not. The SEC more heavily regulates companies but in China there is ironically less regulation (as most people think of China as the “communist” country and the US as “capitalist”, you might expect less regulation in the US)
Looking at what companies were bought out at is a good way to value a company as well. What was the P/E of the buyout price? The PEG? There really is no sure way to value a company. Biotech for example is valued completely upon the ability for FDA approval of it’s drug, and how close to approval and the likelihood of it being approved and how that will possibly impact it’s earnings in the future. Biotech companies are among the hardest to value. Natural resource stocks such as mining stocks are valued based on the price of the natural resources it mines and it’s ability to expand and get new mines and possibility of it’s discoveries and the future outlook of the natural resources same goes for many oil wells and service and oil driller and oil holding trust companies.
Earnings based valuations (price to earnings ratio, PEG, etc:
An earnings based valuation can be done in one of two ways, either using the data you have now, or by projecting a companies earnings into the future. If you want it’s earnings now look at a companies P/E ratio. If the EPS is $1 per share and the price is $20 the P/E is 20/1 or 20. On the other hand, you can divide 1 by the P/E to get the E/P or earnings yield. 1/20 is .05 or 5%. This is how much one year of earnings will yield back for the investor. In other words, someone who had complete ownership of the company would pay $20 per share for every share to buy it out. For every share they got they would directly receive $1 in earnings the next year. They would receive a 5% return on their investment in the first year. If they continued to get $1 it would take them 20 years until they get their investment return, assuming they don’t reinvest the earnings. As an individual shareholder of a public company, you are hoping that others will recognize the value, and as the earnings improves the book value of the company, eventually they will buy and the stock price will increase to reflect the changes of the company.
However, what if in year 2 they get $2 in earnings, and in year 3 they get $4 in earnings. The earnings growth would be geometrical and grow at 100%. Before you know it the company would be worth much more than it is now. For this reason, many people like Warren Buffet might project the company’s earnings forward by several years. However small difference in earnings growth predictions will make a huge difference in the results, and as such guys like Warren Buffett only choose companies that they understand and know well, and companies that have predictable earnings. Without the predictability you are at risk of a big loss that will be difficult to recover from. Additionally it’s a lot easier to value a company if you know what the earnings will be, rather than just guessing what they might be. Lets pretend that this P/E of 20 has EPS of $1 and price of $20 and the EPS growth is 50%. Where will the company be in 10 years? The earnings will in fact be $57 per share.What if we are wrong and instead the company grows at 50% the first year, 40% the next year 35% the next year 30% the next 2 years and then 25% the remaining? The EPS would then only be 14.6 at the end of year 10. While this still may represent decent growth in earnings over 10 years, it shows that valuing a company is not easy, and how this investment compares to a more stable earnings of 30% stable growth in a company that is $20 with a P/E of 10and $2 EPS would drastically depend on which of the 2 exqaamples the company follows. The 2nd company would be better if the earnings of the 1st one dropsas explained in the second example as it would have an EPS of $27.57 in 10 years.
Valuing a company can be either adding up 10 years of projected earnings and just saying that is how much the company is worth over a 10 year period, or instead looking at the PE after 10 years and looking at the historical valuation of this particular industry. For example, if the stock is P/E of 10 with earnings growth of 30% over 10 years, we can either add up the earnings to get $110 in 10 years, or instead we can look at the final year earnings per share of $27 and at a historical valuation of maybe a PE of 16 for that industry, we multiply that $27 by 16 to get $441. These two methods in this example are drastically different, again illustrating why valuing a company can be so difficult. Additionally, if a company excels and grows quickly, it will soon become a bigger cap stock, which means it will be increasingly difficult to grow. Imagine a beverage company that is growing well and is very small so it only has to compete with smaller companies. Then it contrinues to grow fast being a hundred millon dollar company and soon a 1 billion. Now you want to invest in it’s growth but you may not notice it until it’s a billion dollar company because it may not even be publically traded for awhile, and when it does it won’t have proven growth to track and when it does it may be valued in the billions. Now it is increasingly difficult to go from $1 billion to $10 billion compared to going from $100 million to $1 billion. If the company keeps growing, soon it will have to compete with Coca Cola and Pepsi rather than Jones Soda and Shasta and other smaller names. It may have sold well at all the mom and pop businesses and kwikimarts and gas stations of the world, but how will it do as it moves into major retail and starts a vending machine route. Will stores even put it in, or ould stores prefer the coca cola machine which may produce many more sales. Will the company be a fad that eventually ends, or will it actually compete. The chances of it being able to overtake the brand of Coke or Pepsi is very unlikely. As such the growth may not continue at the same rate forever, and generally not only is valued at a lower premium as it reaches it’s growth potential, but will probably be less likely to continue to grow. As such, using this value method while well intentioned and maybe even the best you can do, it may not be correct. The good news is, you are not the only one imn this issue. If you play tag blindfolded, while everyone else has there eyes open, you will not have a good chance. But if everyone else is blindfolded, you have as good as chance as any. So it’s difficult for others too, not just you.
Also, a shortcut to projecting the earnings forward, is to just value companies by their PEG or price to earnings growth rate. Lower is better as with the P/E. a P/E of 1 could be said to be half the price based on it’s earnings growth as a PEG of 2 and therefore it could be said to be twice as valuable with all other things being equal (which is great in theory but may often not be true in real life).
Revenue based valuations (price to sales valuation): If a companies price to sales is low, it’s earnings may increase. Rather than projecting the future earnings, you can just look at sales as an indicator of future earnings and recognize that the more undervalued a stock is relative to it’s sales, the more likely a company is undervalued to it’s future earnings. So look at a companies price to sales, the lower the better. More importantly look at similar companies, the way you would look at similar properties in the area if you were buying real estate. Look at the companies in the industry that have similar numbers and see how they compare. What is the average price to sales ratio of the company vs the price to sales average of the industry? of the sector? If you prefer looking at valuing a higher number as better, you can of course reverse this and use a sales to price yield just like you did with earnings and take 1 divided by the p/s ratio. The difference is sales effects future earnings. Sales can be manipulated by reducing prices just to make the sales look good while the earnings suffer, but the idea is that the company will bring in more loyal customers through this manipulation so it’s not always a bad thing. The difficulty is, how do you really use P/S to assign a value to the company?
A P/s of .5 should be 2/.5 or 4 times more valuable than a P/s of 2. You can look at the average p/s divided by the P/S of a company and use that as the “multiplier of the current price. For example, if the sector average (or better yet industry average) p/s is 2.5 and the company is 2 you take 2.5/2=1.25. Multiply this by the current price of the company and you will get the valuation which will be 25% higher than it’s current value.
No valuation method is that great in a vacuum, but using all methods and considering which ones are more important will help you identify which stocks to buy, and which stocks to invest more money in (you should generally weight your portfolio according to value so you have more money in the stocks that represent greater value.)
Equity based valuation (price to book value)
Some say a company is worth all peices of it’s business sold individually minus it’s liabilities. This also may be referred to as “liquidation value”. Many say the sum of all parts is not always equal to the whole though. For example, a company that coul sell all it’s inventory, pay off the debt and have excess cash of $1 billion afterwards, would be said to have a book value of $1billion. If the market cap was 500million the price to book value would be 500M divided by 1 billion or 0.5. The company would be significantly undervalued. In some cases, a company is not in a position to manage it’s debts, in other cases, the company can not simply sell off it’s peices of the business so easily and what’s on the books as it’s value, may not be it’s true value as is the case sometimes after a major crash in the price of that inventory. By purchasing these you must be aware of the situation, because whether or not it’s undervalued may depend on the price of steel rebounding to previous levels just as an example. In some cases the company is more dependent upon earnings than book value as the book value will grow. So in some cases, the company will be much more valuable because of it’s ability to produce in the future. For example, if you just look at McDonald’s properties, you are missing a huge peice of the business. If a famer bought out the little mcDonald’s real estate or even had the same number of square feet of land in good farming land, it would not be worth very much. If McDonalds bought a little peice of farmland in a developing area where shoppin centers and other areas are coming up, it would be worth much more. McDonalds has “intangible” value which is the company brand, the earnings and earnings growth, customer loyalty, etc. Coca Cola doesn’t have aluminum and the actual components of it’s soft drink hat gives it’s value, it converts that into earnings. So there are serious drawbacks to this model UNLESS you are able to somehow give a number to the intangibles yourself effectively. What would Coca Cola pay to have Pepsi’s brand loyalty and take out their competitor? What would Google pay to have Apple’s brand loyalty or to have Steve Jobs as the CEO or to have the constant innovative product lin? What would Microsoft pay to have Google’s advertising program and search user loyalty? Figuring these things out is not easy, which can make such a model of valuation not so difficult. However, take a mining company. It doesn’t really have competative advantages, nor does it really need it. As long as it has access to lots of gold and land for future gold access, it will produce earnings. You could simply look at how much gold a mining company has access to after looking at it’s book value and determine it’s value. A timber company would be worth the value of all it’s timber. Buying at a significant discount is to book value is important as it will help you find good deals, assuming the company can stay afloat. So if you are going to use book value as a ways to investing in a company and valuing it, you probably want to make sure other criteria is in place. A company must already be “good” if it is already “good” and has low book value it may be a bargain. Don’t be afraid to pay more for a good company when using the equity valutation model. Additional return on it’s equity is also important. The ROE will measure how well a company invests this equity to produce growth. High ROE means high future book value. So you might take a companies book value per share and use it’s ROE to project it’s bookvalue in 10 years the way you did with the earnings so the company should be worth what the Bookvalue per share is 10 years from now, but must also be compared to a fixed interest rate of say a treasury bond. This is a much more preferred method than just the price to book value without considering ROE, but as with the earnings projection the weakness has the drastic possibility for large error given even a small error compounded over a long period of time. Just using book value however is a problem. Say a company is worth $1billion and is valued at $500 million. What if 10 years later the price has not reached “fair value”? Your 100% return turns into an annualized return of only just over 7% per year. This method values a company but does not give a set amount of time for when the company will be worth that much. Additionally, it misses out on the companies that are possibly overvalued but will grow their book value over time. However, considering book value valuation as just one component of your evaluation may be a good idea. But considering the book value with the ROE projecting the value forward may be even better. The ROE can obviously cary greatly, so just as with earnings, you need a predictable business, or else find one that has a projection that is head and shoulders above the rest to make up for it, and a smaller investment size to compensate for the increase risk of tying your money up in something that doesn’t produce a great return.
Company solvency valuations: The more solvent a company is, the more undervalued it is in rare situations such as deflation and forced selling. In deflation, cash is king, debt becomes increasingly dangerous, and cash becomes more valuable. The cash rich companies in deflation can buy out other companies. In periods of drastic forced selling, you might see a company such as FCX and TX were, where they had more cash on hand than the company was worth. That is their balance sheet was such that after paying off all the debts, they had a cash excess that exceeded the market cap. This is generally insanely rare evaluations that only occur when the bears are giving the stock away due to the unloading of margin positions, while others also fear global banking default. But thatA companies book value is important, but it’s quick ratio and it’s cashflow and it’s low debt levels becomes important. Valuing a company purly on it’s cash on hand after subtracting it’s debts and comparing that to the book value is only something that can be and should be done in major deflation because there will be so many deeply undervalued companies to choose from, but at the same time a lot of risk of lower prices, and fears of a complete financial meltdown that everyone needs to sell stock and aise cash to pay off their own debt and meanwhile banks may continue to increase restrictions on the amount of capital for margin accounts and for interest rates. In rare situations, you can own a company for free essentially. That’s not to say that you can’t get shares without paying cash, but it is more like buying a treasure chest for $100 that contains more than $100 in cash. You may not be able to find the key at the moment, but you know you have it, and it’s only a matter of time before you can gain access to the cash (when other traders are done deleveraging and when the banks start lending and the credit gets moving again.) It’s a little bit different than that metaphor because you actually gain access to it’s business as well. The only potential issue is if in fact there is global deflation and the banks never start lending again and no one is there to borrow because everyone deleverages until all the credit is deflated. Even so, the company still is sitting on enough cash and even if it’s inventory is useless, at some point the company can be bought out completely and the person buying it gains access to the cash. Of course its rare but possible that the shareholders don’t reject a buyout that is above where you bought it becuse they are that desperate for the money and rthere are no buyers, but that would be an absolutely financial armegheddon situation, and if you aren’t going to invest when everyone fears the worse (yourself included even) you shouldn’t invest in the first place, because if you think this situation is possible and likely, most likely when everything actually hits the fan it isn’t any more possible or likely than before, people are just starting to notice it and watch it unfold.
The other thing about company solvency valuation is about reading the balance sheets. If a company is insolvent that means they will go bankrupt. shares in this company should be shorted. The more sound the financial statement, the more confidence you can have in you other valuations. It’s not really so much a valuation method as it is something that should increase the confidence in your other valuations. Things should be quick ratio and cash ratio. Cash on hand and long term debt. Debt/equity and things of this nature. Cashflow positive companies are a plus, but don’t write off those with no cashflow if the cash is flowing into assets.
Price Target Valuations:
There are many ways to use price targets. You can either look at an analysts price target and put your faith in them, or you can use technical analysis and put your faith in that. Technical analysis will give you price targets depending on the price target. The general principal behind technical analysis is that you usually will expect a pattern to extend from it’s base low to it’s base high, that’s where it breaks out and the amount it’s target price is, is the difference between the base high and the base low. This is not always the case, and sometimes the price pattern will have two different targets depending on if you are a swing trader or trend trader. However, these price targets will generally be met more than 50% of the time, making them profitable patterns if you can successfully manage your downside with stoplosses, and if the stock doesn’t stop out and then reach it’s target a high percentage of that over 50%. Technical analysis is generally more of a short term trade, which is usually not so compatable with value investing for long periods of time. However, you can combine the two. The advantage is, generally technical analysis will give you a shortened timeframe from which to expect the price appreciation, and will generally give you clues when institutions are buying.
I believe that all valuations have their strengths and weaknesses. By considering all evaluations before buying stocks, you stand a better chance of avoiding a mistake. It’s possible that a companies earnings are derrived from large price hikes that jeopordize sales. It’s equally possible that a companies sales are manipulated by artificially low prices. A company with good earnings may also be having temporary earnings such as a one time contract approval, or sale of their cash producing assets or excess inventory, and as a result may suffer lower earnings in the future. By using a combination, you provide the best chance of having a more accurate evaluation, or at least a more stable one. It’s important to weigh each factor with a certain confidence. If earnings doesn’t seem to be important in an industry, you would provide a lower weighting.
I consider good valuation of a company part of “Buffettology” even if it includes other factors, because of Buffett’s ability to identify such companies, but with all these things in mind, you should be able to identify stocks that are undervalued. As long as you manage risk, you should be able to find a good investment to hold for a long time using the correct combination of these things. I will be posting a video on the methodology shortly.