COMPANY VALUATION: DETAILS OF A STOCK IN PLAIN ENGLISH
The U.S. stock markets get plenty of attention on broadcast television, cable news, social media, blogs and chatrooms, even at the office watercooler. The attention isn’t always unwarranted. After all, U.S. stocks account for roughly half of the entire worldwide stock market. Unfortunately for investors, more information doesn’t always mean better information – or better decisions.
In this article, we’ll offer a basic explanation of several methods for evaluating individual stocks. Even if you have no interest in “stock-picking,” these concepts should prove useful for a variety of purposes:
- Understanding how and why headlines are affecting certain stocks
- Interpreting the recommendations or opinions of a financial advisor
- Researching your own investment ideas
- Putting historical performance of an investment into context
For most large U.S.-based companies, there is already a ton of financial information available to the public. Hundreds of different economic indicators and news items guide stock prices over the short-term as traders place bets on near-term results of a company and the economy overall. Analysts research every aspect of a company’s current financial condition and forecasts for future earnings. In some cases, dozens of investment banks might post their own official analysis of a particular company, including their own estimates of the company’s current and future “target” stock prices.
Analyst opinions are rarely unanimous, but a consensus often emerges about whether a stock’s current price reflects its fair market value. If there is an overwhelming consensus that the stock price is significantly overvalued or undervalued, the opinions can have a significant and immediate impact on a stock price. Sometimes the opinion of a single prominent analyst can drive a stock’s price higher or lower.
These analysts ostensibly stake their reputation on the recommendations in their reports, and many of them are eager to soak up the spotlight debating their opinions with other financial “experts” in the media. Sadly, the most prominent “experts” aren’t always the most accurate.
The financial press is its own form of showbusiness, where media outlets often reward the loudest and most outlandish opinions with extra airtime for the sake of spectacle. A company would love to get a consensus “buy” rating from analysts, but consensus isn’t always good for television ratings. Even if 19 out of 20 analysts are in agreement, TV producers will always be tempted to offer airtime to the on contrarian to debate the other experts. That’s how financial news outlets have up with 30 people talking at the same time: rabble rabble rabble, blah blah blah. If you watch enough of these shows and read enough blogs, it’s easy to come away with the impression that every single decision is the most important one you’ll ever face, and that there are only two possible outcomes: instant billionaire, or instant bankruptcy.
Thankfully you don’t need to focus on most of this financial theater. If you concentrate on building a diversified portfolio containing a variety of investments, your success won’t depend on the success or failure of any single company. Because none of your decisions are all-or-nothing, you don’t need to obsess over ALL of the minutiae and conflicting “expert” opinions. Instead, you can use a few simple data points to help decide whether an individual investment offers a reasonable return at its current price. You can also use the same concepts to compare relative return opportunities for two or more investments.
We are going to take the ocean of information provided about a stock and summarize it into three points to explain what drives the price of a stock. Add these to our long-term bets that we mentioned in the previous section that describes what drives a company’s success in the long-run, and we have enough of a picture to explain a stock price!
When a company earns a profit, it has to decide how best to allocate those excess earnings. Depending on its priorities, a company might choose one or more of the following options:
- Save cash for a rainy day
- Pay down existing debt (improve future cash flow)
- Invest internally (hire people, buy equipment, conduct research, etc)
- Invest externally (mergers, acquisitions, joint ventures, new business lines)
- Consolidate ownership (by repurchasing outstanding stock shares)
- Distribute profits to owners (shareholder dividends)
All of those choices can be good for investors. The first five options represent investments in the financial security and future growth of the company. Those choices might lead to a higher payout for owners in the future, but they also lead to smaller payouts for owners today. Faced with an uncertain future, investors tend to prefer to receive at least some of their profits immediately in the form of dividends.
When companies pay consistent dividends, those cash flows become an important component of an investment’s overall return. By projecting that dividend income into the future, you can build a basic foundation for comparing various investment opportunities.
Don’t bother breaking out your calculator. We don’t need to quantify the comparisons or review the various formulas just to understand the concepts. Here are the important variables:
In theory, a company that pays a dividend today should be more valuable than an otherwise identical company that doesn’t pay a dividend. The bigger the dividend, the better the opportunity. Firms that don’t currently pay a dividend are likely companies that are growing quickly and need to keep the cash to reinvest in their business instead of paying it to shareholders. Once their growth slows they might need to pay dividends just to keep shareholders happy.
All else equal – the less risky a company is the better. If a company is currently paying a big dividend but they are involved in a very risky business (and their net income has been historically very volatile) then you can’t be assured that this dividend will continue forever. However, for a company in a very stable business there is less risk involved and thus a better chance of stockholders getting this dividend. If a risky company finds a way to lower their risk (ie due to a new product patent, or they signed long-term business contracts) then with that lower risk profile their share price should rise.
Perhaps the most important and price-sensitive variable is the company’s growth. If a company is able to consistently deliver growth in their earnings then they will be able to continue to pass more money to shareholders. A company that pays a huge dividend now but that is unlikely to find steady growth in the future is not as attractive as a company who might pay a lower dividend now but has much more promising prospects to deliver long-term growth.
COMPANY BUYOUT PROSPECTS:
Small investors will usually focus on dividends as the source of their cash flow on their investment. But larger institutional investors and some companies prefer to focus their research efforts on acquisitions. Mature companies in mature industries might find their own growth prospects limited. Instead of eking out modest gains by reinvesting in their own business lines, they might look to buy smaller companies with higher profit margins or untapped growth potential. In such a takeover, the larger company would acquire all of the assets and all of the future cash flow achievable by the smaller firm. The acquirer could continue to reinvest the profits of its legacy business into this “new” and more profitable subsidiary in order to improve the company’s overall growth prospects.
If the takeover targets are already profitable, they could choose to keep their control – and their profits – to themselves. Acquirers often need to offer a premium price to convince the owners of the smaller firm to sell. Historically, acquisition targets have demanded a premium of about 30% over their current share prices in order to agree to a deal.
If you could identify and invest in takeover candidates early on, you would be in position to benefit from the acquisition “premium.” The most attractive takeover targets tend to be smaller competitors or suppliers with high profit margins in industries where acquisition and consolidation are already common. Think of small and mid-sized companies within financials, pharmaceuticals, biotech, niche industrials, natural resources and materials, energy, computer/networking components, media/entertainment.
It’s unrealistic to think that you can consistently predict M&A activity in advance, but you don’t need to. By focusing on companies with positive cash flow and high growth prospects, you stand to benefit over the long term even acquirers never appear. On the other hand, the excess return from an occasional, successful takeover might raise the overall return for your entire portfolio.
The third main driver of a stock price is its relative valuation – or the price of a company compared to other similar companies in the same industry.
A common measure of a company’s value is its “price to earnings” or “P/E” ratio. The ratio helps us understand how much the market is willing to pay for a company’s future earnings. Dividing the projected per-share earnings of a company by its current share price, we see how much “value” the market attaches to that company. Here’s an example:
- If ABC company stock trades for $50 per share and it expects to earn a net profit of $5 per share over the next year, the P/E ratio for ABC would be $50/$5=10. This suggests that investors are willing to pay only $10 for each $1 of ABC’s future earnings.
- If XYZ company is also priced at $50 per share but it expects earnings of only $2 per share in the future, its P/E ratio would be $50/$2=25. Investors are apparently willing to pay much more ($25) for each $1 of XYZ’s future earnings.
If the two companies were otherwise identical, it’s unlikely that such a disparity would exist between the “relative value” of earnings for ABC and XYZ. In this example, ABC looks like a much better deal if we only have to pay $10 for each $1 of future earnings. We say that its stock appears much “cheaper,” relatively speaking. In reality, investors would only be willing to pay 2.5x as much for each $1 of XYZ’s projected earnings if they thought the *real* earnings opportunity was in fact much greater over the long term.
Overall valuation metrics tend to ebb and flow over time. This ratio will vary greatly across companies and over time. Older and slower growing companies tend to trade at lower relative valuations. Younger and faster-growing companies might trade at very high relative valuations.
Interest rates, inflation expectations, risk tolerance, regulatory environments, and countless other variables all play a role. That makes it impossible to conclude that any investment is good or bad based solely on its P/E ratio at a moment in time. Even if the P/E ratio of a single stock tells us very little on its own, we can still use the ratio as the basis for lots of important comparisons:
- Head-to-head: Does Coke or Pepsi look like a better investment opportunity right now, based on their relative stock prices and projected earnings?
- Rear view mirror: At today’s prices, does Apple look like a better or worse investment than it did a year ago?
- Peer pressure: Does Pfizer look more or less attractive than the “average” healthcare industry stock at today’s relative valuation?
- Lifting Weights: If one or more sectors look “cheaper” than all of the others, should you increase your weighting to those sectors to take advantage of the implied “sale” on earnings?
Keep in mind that “expensive” stocks are not always bad investments. Plenty of companies have delivered phenomenal investment returns despite relative valuations that might have looked expensive all along the way. Similarly, a relatively “cheap” stock is not necessarily a great deal. If a P/E ratio implies a fire-sale stock price, you might just find that the fire is still burning.
Historically, investment strategies that emphasize relative value have also delivered relatively higher returns. Just don’t mistake relative valuation for absolute truth.