- There are many valuation indicators available to value stocks
- Different indicators give widely differing valuation numbers making it difficult for investors to come to a conclusion
- The best way to decide is ironically not to decide yourself but instead let the data decide which indicator is best
Many valuation indicators
There are many ways to value a stock. Each has its own following among investors and probably each can be traced to an investment guru that popularized it.
The most common stock valuation indicator is undoubtedly the Price to Earnings (PE) ratio. It measures how many times you are paying for a stock in comparison with its earnings. It is intuitive and can be used to compare companies from a wide range of industries with widely differing profit margins. It doesn’t matter if you are valuing a biotech company with 40% net profit margins or a discount store with 3% margins because we are looking at the bottom line profit number, which already takes into account the margins.
To use this method, we find out the average PE ratio that the company traded at in the preceding years and multiply this by its current or future earnings per share.
Since bottom-line net profit may experience wide swings due to factors that are not entirely within management control, a variation of the PE ratio is sometimes used – the Market Cap to EBIT (Earnings before Interest and Tax) ratio – to take away the effects of taxes and interest payments that are not entirely within management’s control.
Some companies may currently be in a loss position and may even be expected to be in a loss position for the next few years. This makes PE not an appropriate method to value the stock. To overcome this, the Discounted Cash Flow (DCF) Method is used as it takes into account earnings way into the future and apply an appropriate discount rate to it.
Cash Flow-based Valuation
Accounting profits can be subject to manipulation. Therefore, some investors prefer to value a company based on cash flows generated by the operating activities of the company. It also acts as a reality check to the PE ratio because if a company generates high profits but not operating cash flows, it could be heading for trouble since it is cash that pays the operating expenses. A company could record high profits but low cash flow because cash is tied in working capital. For example, products are sold to customers at a profit but they are sold on credit and the company has difficulty collecting cash from its customers. Or money earned by the company could be tied in excessive inventory, which saps up cash flow. In addition, some companies could be resorting to creative accounting methods to inflate earnings. All these reasons make some investors prefer to use cash flow to value a stock rather than earnings. A simple way to value a company based on operating cash flows is to use the Price to Cash Flow ratio.
Just as the PE ratio could be inappropriate because the company is experiencing a loss, the Price to Cash Flow ratio could be inappropriate if the company is experiencing negative cash flow now or in the next few years. The Discounted Cash Flow Method can also be applied to cash flows instead of earnings to arrive at the stock value.
Another cash flow-based valuation method is the Earnings Power Value. This is a method developed by Columbia University Professor Bruce Greenwald. This method calculates a stock’s value by the formula: Adjusted Earnings / Cost of Capital. Adjusted earnings is derived by deducting from accounting earnings capital expenditure that is required to maintain the operations of the company. Therefore, it is quite similar to free cash flows. The cost of capital is the required rate of return of the company to make its business worthwhile.
The Price to Sales Ratio is a commonly used valuation indicator for a stock. While not as popular as the PE Ratio, it can be used even when the company is not making a profit or only making minimal profits. However, it should not be used by itself because a company may be achieving sales but not profits, which means the company is not generating value. Using this method, we find out the average Price to Sales ratio of the company in the preceding years and multiply it by the current or future sales of the company.
Price to Earnings, Price to Sales and Price to Cash Flow ratios all value a company based on what it is generating (i.e. profits, sales or cash flow). Valuing a company based on Book Value (i.e. Assets minus Liabilities) is different because it values a company based on what it owns. This is usually a suitable valuation indicator for a financial institution, which frequently revalues its assets and liabilities, or a company with huge asset base e.g. industrial or utilities company. The book value provides a theoretical liquidation value of the company.
The most common way to value a company based on assets is to use the Price to Book Ratio. Using this method, we determine the average Price to Book Ratio that the company traded at in the preceding years and multiply this by the current or future Book Value of the company.
When using book value to value a company, investors usually take out intangibles such as good will and other reserves because these usually do not fetch any value when a company is liquidated.
The Net Current Asset Value method also values a company based on its assets. It goes by the formula: Stock Value = Cash and Short-Term Investments + (Accounts Receivables x 75%) + (Inventory x 50%) – Total Liabilities
Instead of taking into account Total Tangible Assets minus Total Liabilities, it takes into account only current assets and ignores long-term assets (like plant and machinery) because these are usually worthless when a company is in liquidation. Even current assets are adjusted downwards to reflect the fact that in a liquidation event, not all of receivables can be collected and not all or inventory can be sold for cash. From this adjusted current asset value, we deduct the total liabilities of the company.
For stocks that have a history of paying meaningful dividends, the stock price is often dependent on how much dividend the company pays. Many stocks that pay high or consistent dividends e.g. REITs would fall into this category.
When we value a stock based on its dividends, we calculated what is the average Dividend Yield (dividend / stock price) in the past and apply this to the current or future dividend.
Composite Valuation Indicators
Instead of valuing a company purely using earnings, sales, cash flow, book value or dividends, some methods employ a mixture of these.
The Projected Free Cash Flow (FCF) method combines cash flow with book value. This method calculates a stock’s worth as follows: Stock Value = (Appropriate Multiple) x 6-year Average of Free Cash Flows + Total Equity x 80%. Free cash flows are cash flows available to the company after it has deducted what is spent on capital expenditure. A 6-year average is used to smoothen the number as free cash flows tend to be volatile. The formula then adds 80% of the Equity value because it attributes part of the value of the company to its asset backing.
The Graham Number (named after Benjamin Graham) is another composite valuation indicator but it combines earnings with book value. It takes on the formula:
Graham believed that the PE ratio should not exceed 15 and the Price to Book ratio should not exceed 1.5. Hence Price/Earnings per Share x Price/Book Value per Share should not exceed 22.5 (which is 15 x 1.5). This reasoning result in the above Graham Number and stocks that are considered cheap are those that do not have prices that exceed this number.
Different indicators give you different conclusions
It is necessary to use different valuation methods to arrive at a suitable valuation for the stock. This is because while each valuation method has its benefits, it also has its shortcomings. Earnings and Cash Flow-based methods are meaningless when the company has negative earnings or cash flows. Sales-based method is more stable because sales are never negative. However, this does not tell us whether the company is able to sell profitably. Asset-based methods give us an indication as to how much we are paying for the company’s assets but assets are not directly related to a company’s profitability.
While it is important to value stocks based on multiple indicators, they sometimes lead to differing views on valuation. One indicator may tell you a stock is overvalued while another tells you that it is undervalued.
Take a well-known stock like Apple Inc. The following chart shows the stock value of Apple calculated using different methods.
Which method should an investor rely on? Depending on the method he chooses, Apple’s stock could either be a strong buy or a strong sell.
Usually, an investor chooses the method that he likes based on his agreement with the rationale behind the formula or his affinity to the inventor of the method. However, it is dangerous to rely on any indicator without first confirming mathematically or visually that this indicator has done a good job in explaining the stock price in the past. If past stock prices show little correlation to the stock value determined by this indicator, why should this indicator be trusted to tell you what its current value should be?
What if an investor wants to rely on several methods to give him the stock value? How should he combine the different methods? Should he combine Price to Sales with Price to Earnings or Price to Book with Price to Cash Flow?
These are difficult questions and I would like to suggest that rather than subjectively choosing which indicators to adopt, we let the data decide. By this I mean, we should combine the different indicators and mathematically choose the combination that has the best explanatory power of past prices. Our best bet is to rely on this Composite Indicator to tell us how future prices should behave.
Let’s see how this methodology applies to Apple Inc. (AAPL)
We first look at valuation from the standpoint of popular indicators – Price to Earnings, Price to Sales, Price to Cash Flow, Price to Book and Dividend Yield.
At the price of USD190.58 as at 10 Jul 2018, Apple Inc is trading at a PE Ratio of 17.1 times last 12 months earnings. This is a 19.1% premium to its historical average Price to Earnings Ratio of 14.4 times. (Price based on the historical average PE of the company is indicated by the red line.)
At the price of USD190.58 as at 10 Jul 2018, Apple Inc is trading at a Price to Cash Flow Ratio of 13.4 times last 12 months cash flow. This is a 32.0% premium to its historical average Price to Cash Flow Ratio of 10.2 times.
At the price of USD190.58 as at 10 Jul 2018, Apple Inc is trading at a Price to Book Ratio of 8.0 times current book value. This is a 53% premium to its historical average Price to Book Ratio of 5.2 times.
At the price of USD190.58 as at 10 Jul 2018, Apple Inc is trading at a Dividend Yield of 1.4%. This is a 15.7% premium to its historical average Dividend Yield of 1.7%. (Note: The lower/higher the dividend yield, the more expensive/cheaper the stock is.)
As explained above, I believe that rather than subjectively choose which indicator to rely on, it is better to let the data decide and choose the combination of indicators that is best able to explain the stock price mathematically.
Using past data, we found a Composite Valuation Indicator that uses a combination of indicators that explains the stock price better than any of the standalone indicators above. And it gives you one conclusion on the stock – is it under or overvalued and by how much.
Based on the Composite Valuation Indicator, the stock has a Target Price of USD183.15 within a 12-month period. Our Target Price represents downside of 3.9% based on stock price of USD190.58 as at 10 Jul 2018. The target price takes into account the appropriate valuation of the company and its future fundamentals i.e. profit, sales, cash flow, book value, dividends, etc.
There are many methods to value a stock. This is good as different indicators have different strengths and weaknesses. However, the problem with using different indicators on a standalone basis is that we end up with different conclusions and not knowing how to act.
Rather than subjectively choosing our favorite indicator, it is better to let the data decide. First of all, we run the numbers over a long period and determine the average valuation based on earnings, sales, cash flow, book value and dividends. We then combine these standalone indicators in different permutations until we find the combination that can mathematically explain the stock price best. This Composite Indicator is the one that gives us the highest confidence of how stock prices will behave in future.
Source of Data: Valuation charts are from the ProThinker Stock Report. Company description, historical financial statements data and price data are from gurufocus.com. Estimates are from gurufocus and/or 4-traders.com – Thomson Reuters.
Disclaimer: This report is for information purposes only and should not be considered a solicitation to buy or sell any security. Neither ProThinker nor any other party guarantees its accuracy or makes warranties regarding results from its usage. Redistribution is prohibited without the express written consent of ProThinker. Copyright(c) 2018. All rights reserved.