Diversifying too much can make you lose money
Stock valuation is a method for valuing companies and their stock prices. Generally, there are two approaches.
The first is to take a company’s market valuation (using its current price) and assess whether it’s fair in relation to the company’s prospects.
The second approach is to calculate a theoretical valuation share price which you then compare to the current market price. If the calculated price is above the current price then the stock is considered undervalued, which might be a signal to tee up a buy order.
If the calculated price is below the market price then this would indicate the stock is overvalued and it could be time to ship out the shares and look for another opportunity.
For investors new to valuing shares, it’s important to remember value and price are different.
Just because a price has fallen doesn’t necessarily mean the stock’s better value. Equally, a stock that has seen its share price skyrocket won’t always be more expensive than before the rise.
That’s because the outlook for a company’s profits can change, and it can change dramatically. A stock can go up a lot but still be good value if the company’s prospects have improved even more.
Valuation methods aim to figure out what a company is worth and then translate that into a price. We all know whether something is more expensive than something else. But sometimes, it can be worth it.
In the 1980s a Fairy Liquid TV ad showed two long dinner tables side by side, one with a lot of places set and the other with far fewer.
The point of the ad was a bottle of Fairy Liquid could wash a lot more dishes than a cheaper imitation could, making it better value, according to Procter & Gamble, Fairy’s maker.
Valuing stocks is a similar idea, it’s about what you get back for the price you pay.
When thinking about investing in stocks, you might ask yourself whether they are cheap or expensive? But the price, on its own, tells us nothing.
The actual share price is irrelevant. In investing, unlike in the real world, a lower price doesn’t make a stock cheaper. So NKE’s lower price doesn’t make it cheaper than MSFT.
So the first stage in a valuation process is to ignore the absolute share price. And from there it's a two-step process.
The first is to determine whether the shares are cheap or expensive, using techniques like ratios, more on that later.
The second is to find out whether the stock, being cheap or expensive, is good value or not. Here it's important to remember that cheap doesn’t necessarily mean good value and expensive might not be bad value.
These two pieces of analysis overlap, but for simplicity let’s tackle them separately.
A few basic investing ratios are a necessary first step when conducting valuations. Let's stick with our example and focus initially on MSFT.
Past performance is not a reliable indicator of future returns.
Source: Koyfin, as at 5th April 2022. Basis: local currency terms with income reinvested.
If you buy one share of MSFT, you’re entitled to one share’s worth of MSFT’s economic worth. So for that initial $311 you get one share’s worth of the business - that includes its profit, dividends and cash flow.
Some of the ratios to help figure out what those proportions look like include profit per share (also known as earnings per share or EPS), dividend per share (DPS) and cash flow per share (CFPS).
To calculate anything per share, like EPS or DPS, take the total company amount and divide by the number of shares. So the total earnings for the company/number of shares = EPS. And the total dividends for the company/number of shares = DPS.
Then there’s a company’s market value. The price per share of MSFT is its total company value (known as market capitalisation or market cap) divided by the number of shares.
Our per share calculations give us our first set of ratios in the table below.
In practice, it's unlikely you would have to calculate per share ratios. Most data sources and all company financial filings will arm you with the per share information shown below.
But we need to understand per share ratios because common valuation metrics are quoted on this basis.
Source: Koyfin. Basis: current FY estimates for sales and profits (as at 8 April 2022), current market value, shares outstanding and trailing 12-month dividend payments.
Once we have calculated per share ratios we can combine them with price to give us some basic valuation ratios.
Here are some examples of what those could look like.
Price / earnings (P/E) = Price per share / earnings per share = $311 / $9.5 = 32.7
Price / sales (P/S) = Price per share / sales per share = $311 / $26.5 = 11.7
Price / dividends = Price per share / dividend per share = $311 / $2.4 = 129
Normally these ratios are presented as a multiple. For example, you would see the MSFT share price quoted as having a P/E of 33x earnings. This means the MSFT share price is 33x its current EPS.
Eagle-eyed readers will have noted dividends are never quoted as a ratio. No one would say MSFT trades at 129x dividend per share (DPS). Instead, MSFT would be quoted as having a dividend yield of 0.8%.
For the mathematically inclined, price / dividend expressed as a ratio is the same as dividend / price expressed as a yield. For example:
Price = $10
Dividend = $1
Price / dividend = $10 (never used)
Dividend yield = $1/$10 expressed as a % = 10% (always used)
In isolation, similar to our initial comment on price, a valuation metric doesn’t mean much. When talking about P/Es, what does a P/E of 25x, 15x or 50x mean?
What It actually tells us is that if a company earned the same level of profit year after year, it would take the same number of years as the P/E to recover the initial investment in EPS.
For example, a P/E of 33x for MSFT means that it would take 33 years’ worth of EPS to recover the $311 you shelled out to buy one share.
That might sound like a lot of years but if MSFT was doubling its profits every year (it isn’t by the way) then it would only take a little over five years to get your money back.
So looking at a P/E through the lens of the company’s growth rate brings the valuation calculation into focus a bit. More on that later.
The key point here is that a standalone P/E doesn’t take us far enough, we need to do some comparisons.
But what do we compare MSFT’s P/E to?
We could compare it to Nike, which we did at the beginning to show that absolute share price comparisons are irrelevant. Let's repeat the above calculations for NKE.
Source: Koyfin. Basis: Current fiscal year estimates for profits and shares outstanding (as at 8 April 2022).
Price / earnings (P/E) = Price per share / earnings per share = $132 / $3.7 = 36
So NKE is trading on a P/E of 36x and MSFT at 33x, so MSFT is cheaper than NKE right?
Well on this measure alone, and over only one time period as in our example, yes. But what if we compared MSFT price to sales (P/S) with NKE P/S?
Source: Koyfin. Basis: Current fiscal year estimates for profits and shares outstanding.
Price / sales (P/S) = Price per share / sales per share = $132 / $29.3 = 4.54x
MSFT’s P/S was 11.7x. So on this measure, MSFT is more than twice as expensive as NKE.
The reason for the differences in the two valuation outcomes is we are comparing businesses operating in different industries.
MSFT as a software company earns very high profit margins, and so its earnings are a much larger percentage (margin) of its sales than NKE, which has comparatively much lower profit margins.
The point is, a simple valuation ratio comparison of two companies is not especially useful. It makes more sense than a raw price comparison, which tells us absolutely nothing, but we need additional information to paint a more complete picture.
When using valuation ratios to figure out if a stock is cheap or expensive it’s more useful to compare to other companies in the same sector, to the market as a whole (say an index like the S&P 500) or to the company’s own historic ratios. Let's use MSFT again and take each of these in turn.
Source: Koyfin. Basis: current FY consensus estimates for EPS (as at 8 April 2022).
The first thing to note is the wide range of P/Es among this selection of US software companies, so using the average is probably our best comparison.
This could lead us to conclude that, on 33x, MSFT is a bit more expensive than the average of our select group of software companies on 30x.
This is definitely more useful than our comparison with NKE, as the companies above have more in common.
Adding a time perspective takes this a bit further. While MSFT looks a little more expensive than this select group’s average right now, that may not have always been the case.
We can carry out the exact same calculation to compare MSFT to the broader market, represented by an index like the S&P 500.
The S&P 500 trades on roughly 22x, which again would make MSFT more expensive.
We can calculate a ratio of ratios (the fun really never stops), which would conclude MSFT at 33x is 1.5x relative P/E to the S&P 500 at 22x. This relative P/E is commonly used especially when viewed over time.
As recently as 2015, MSFT traded at 1x relative P/E to the S&P 500. In other words, they both traded on around 21x. That means MSFT is more expensive relative to the S&P 500 today than it was in 2015.
The last comparison to consider is how the MSFT P/E looks relative to its own history. If we were to chart the MSFT P/E over the last 10 years we would see it has gone up and to the right.
In 2013 MSFT traded at only 13x earnings. Going from 13x in 2013 to 33x today is what’s referred to as multiple expansion. In a basic sense, because the multiple has expanded.
One final remark on relatives.
Comparing a valuation ratio of one company to another, or to a group of similar companies, or even the market as a whole can yield different results. In our P/E example, MSFT is cheaper than NKE, more expensive than a group of software companies, and more expensive than the market, and especially so today compared to the last five years.
This information taken together actually tells us quite a lot and leads neatly onto the next part of the discussion.
It’s time to figure out whether MSFT is a better investment than those companies or the market as a whole. Or in other words, is it better value?
To properly answer that question we have to start thinking about the future.
The final part of the puzzle is to take our ‘cheap or expensive?’ analysis and consider whether we think this represents good value.
When looking into the future, we can use a ratio like a P/E, and combine that with an assessment of what might happen to the E (the earnings or profit). Above we suggested a P/E of 33x for MSFT may look expensive but it all depends on how fast the E grows.
As we said, if MSFT were growing at a rate where its earnings were doubling every year, then 33x would be pretty good value for the stock. It would take a little over five years to get back in profit what you shelled out to buy the share.
A side note. When we say ‘get back’ in profit it is important to note that you don’t actually get profit as a shareholder. Instead, shareholders receive a proportion of profits that the company decides to pay out as dividends.
But earnings or profit is needed in order to pay dividends, so earnings can be used to represent potential dividends.
The point here is that a P/E of 33x doesn’t tell us much about value without a view of what is going to happen to the E. It might be good value if the E is doubling every year but it’s bad value if the E isn’t growing, or worse, declining.
Let's bring this to life with a theoretical example.
Looking at the P/E column on its own we would assume that Company B is cheaper at 10x vs 16x for Company A, roughly 60% cheaper. But when we consider this relative to the growth in earnings (E) or EPS, Company A looks like the more attractive option.
What the two tables below show is if the share prices of both companies stayed the same, it would take somewhere between six and seven years to double your money in Company A from the initial £80 paid for the share vs somewhere between eight and nine years for Company B.
In this very simplified example, Company A is better value despite it trading on 16x P/E vs 10x P/E for Company B.
This example shows price or P/E alone isn’t enough to decide whether or not the stock is good value. To do that, we need to build an opinion on future growth.
Back to MSFT and NKE. They both appear to be trading on quite expensive P/E ratios of 33x and 36x respectively vs the S&P 500 on 22x. But we don’t know whether this is good or bad value without a proper assessment of how quickly their earnings might grow in the future.
There is also the consideration of how sustainable the growth is in the future and what risks to that growth exist. Both MSFT and NKE have been growing rapidly and this could very well be sustainable.
In general, the more sustainable and predictable growth is, the more investors are willing to pay for the shares.
So from this perspective, MSFT and NKE have both been enjoying outsized earnings growth that appears to be relatively sustainable. So even though their P/E ratios look high, the stocks could still be good value.
So far we have explored the first approach to valuation we identified. Looking at how the market prices a stock with its P/E. Then weighing the ratio against future growth prospects to think about value, and finally comparing that to other companies or the market.
In some ways the second approach, intrinsic value, is a simpler method. The calculation itself is more complex, but the idea is basic. First value the company, then compare that to the market price. Easy?
Let’s dive in.
When investors take an intrinsic approach to valuing companies they are attempting to value the company by calculating what it’s worth.
They then compare that to the market price and, if the price they’ve calculated is above the market price, the stock is considered a buy. If the calculated price is below the market value, it’s not.
Intrinsic value is about forecasting all potential profit that a company might generate into the future, forever, and then converting those future profits into a value today.
Forecasting for any period into the future is challenging, let alone forever, so the calculation is usually broken into two parts.
First Investors forecast for a set period, say 10 years, and then make a giant assumption to capture any profits thereafter. This second part is called terminal value and it usually makes up a large part of a company’s value.
In practice, intrinsic value is about forecasting cash flows and not profit. The reason for this is dividends are paid out of cash flow rather than profit. A company can be profitable but generate zero cash, and so be unable to pay a dividend.
But there are a number of accounting steps needed to convert profit into cash flow and so for our illustrative purposes we can continue with profit as a proxy for cash flow.
After mapping out forecasts for future profits for the specific period as well as the terminal (forever after) value, those profits need to be turned into today's money through discounting.
Discounting is the opposite of compounding.
Compounding is about investing and earning a positive return. If we continue to achieve the same return then the amount we have invested starts to grow by larger increments over time.
Here’s an example of what that might look like.
If we invest £100 today at a rate of return of 10%, that £100 grows at 10% every year. After 10 years, it will be worth £259.
So we turn £100 present value (PV) into a future value (FV) in 10 years by multiplying £100 by the 10% rate of return 10 times.
The actual calculation is £100 x 1.10 x 1.10 x 1.10 x 1.10……= £259
If we did the exact opposite of compounding by 10%, we would be discounting by 10%. In other words, if we divided our FV of £259 by 10% 10 times we would calculate a PV of £100.
£259 ÷ 1.10 ÷ 1.10 ÷ 1.10…….= £100
Here we have turned our £259 FV into today’s PV by discounting (dividing) by the discount rate 10 times.
For a complete intrinsic value calculation, each future (FV) profit forecast is converted into a value today (PV) by discounting by the number of years in the future the forecast is. So the five-year profit forecast is discounted five times, the 10 year forecast 10 times and so on.
The final stage is to add up all the PVs and the result is the intrinsically calculated company value.
The rate we use to discount future profits is the most controversial part of an intrinsic value calculation. There are theoretical models to help, like the Capital Asset Pricing Model (CAPM), but the model isn’t without its critics.
A discount rate has two components, a risk free rate (usually a government bond interest rate) and then an added buffer called a risk premium.
The riskier the profit forecasts being discounted, the higher the risk premium needs to be. Again we can use complicated mathematical models like the CAPM to help, but a pragmatic user of intrinsic value can just use a healthy dose of common sense.
Discounting the profits of a highly cyclical mining company that operates in a politically unstable part of the world needs a higher risk premium than the future profits of an American consumer staples company, like P&G for example.
The reason is that we need to be more careful when discounting riskier companies. If we choose a high discount rate (remember that a higher discount rate will lower the intrinsic value calculation) and still calculate a company value above the current market price we can feel more relaxed than if we had used a lower discount rate.
Common sense rules when it comes to intrinsic value calculations. If investors are conservative with their forecasts (meaning no overly optimistic scenarios) and use a healthy discount rate (rule of thumb would be 7% or higher) and still compute an intrinsic value above the market price then it’s a very solid platform for identifying underpriced investments.
The opposite is true. If pie in the sky forecasts are discounted by a rate that is too low it’s likely that the intrinsic value calculation would point to upside in a stock. But that wouldn’t be very helpful.
We recommend investors stick with the common sense approach and focus on realistic outcomes and an appropriate discount rate.
Ultimately, valuing companies isn’t an exact science. If it were, every stock would be efficiently priced and there would be no outsized gains to be made by anyone.
When you’re beginning your investment journey, valuation techniques might seem a bit daunting. You could be wondering why you can’t just take an educated view on the sales of a business in the coming years and buy a stock based on that.
Well, it’s sensible enough and not a bad place to start. It's definitely a good idea to avoid investing in anything that you think is about to have a run of really poor sales.
But it’s a good idea to try to think beyond that. You could think a company is going to have a good run of sales growth, but the market might be one step ahead and the good news might already be reflected in the price, in other words the stock could be fairly valued.
As we’ve shown, there are plenty of approaches to valuing companies and for developing your own set of investing principles. This guide is a launchpad for investors looking to expand their knowledge of what those strategies look like, and how to use them in practice.
Probably the most important milestone in understanding valuation is to understand what other investors, or ‘the market’, are thinking about a company’s future and how they are pricing its stock accordingly.
This can be done using our ratio analysis examples or by flexing an intrinsic value model to see what the market is forecasting.
In both these approaches, it is maybe comforting to know for retail investors that even the most experienced and finely tuned valuation modellers have to make forecasts that sometimes are no better than educated guesses. And this is the beauty of stock markets.
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