Valuation - The Basics
1. To invest successfully means you need to buy great companies at attractive prices
2. Investors purchase an asset for less than their estimate of its value and receive a return more or less in line with the financial performance of that asset.
3. Speculators, by contrast, purchase an asset not because they believe it's actually worth more, but because they think another investor will pay more for it some point
4. Being picky about valuation isn't fun. It means letting many pitches go by and watching many stocks run - stock that never met your strict valuation criteria.
Using Price Multiples Wisely
Prices-to-Sales
1. The nice thing about to the P/S ratio is that sales are typically cleaner than reported earnings because companies that use accounting tricks usually seek to boost earnings.
2. Sales are not as volatile as earnings - one-time charges can depress earnings temporarily and the bottom line of economically cyclical companies can vary significantly from year to year
3. The relative smoothness of sales makes the P/S ratio useful for quickly valuing earnings, by comparing the current P/S ratio with historical P/S ratios.
4. The P/S ratio has one big flaw - sales may be worth a little or a lot, depending on a company's profitability.
5. Retailers, typically have very low margins - that is they convert relatively small percentage of every dollar of sales into profits.
6. Don't compare companies in different industries on a price-to-sales basis, unless the two industries have very similar levels of profitability.
Prices-to-Book
1. Compares a stock's market value with the book value (aka SHE or net worth) on the company's most recent balance sheet
2. Legendary value investor Benjamin Graham, was a big advocate of book value and P/B in valuing stocks
3. For service firms, in particular, P/B has little meaning.
4. Another item to be wary of when using P/B to value stocks is goodwill.
5. Goodwill often represents little else but the desperation of the acquiring firm to buy the target before someone else did, because acquiring firms often overpay for target companies.
6. P/B may be low, but the bulk of the B could disappear in a hurry if the firm declares the goodwill as "impaired" and writes down its value
7. P/B is also tied to ROE in the same way that P/S is tied to net margin. Given two companies that are otherwise equal, the one with higher ROE will have a higher P/B ratio
8. P/B isn't terribly useful for service firms, it's very good for valuing financial services firms because most financial firms have considerable liquid assets on their balance sheets.
9. The nice thing about financial firms is that many of the assets included in their book value are marked-to-market in other words - they are revalued every quarter to reflect shifts in the market place, which means that book value is reasonably current.
Price-to-Earnings: The Benefits
1. The nice thing about P/E is that accounting earnings are much better proxy for cash flows than sales, and they're more up-to-date than book value.
2. A company that's trading at a lower P/E than its industry peers could be good value, but remember that even firms in the same industry can have very different capital structures, risk levels and growth rates, all of which affect the P/E ratio
3. All else equal, it makes sense to pay higher P/E for a firm that's growing faster, has less debt, and lower capital reinvestment needs
4. Few questions that can distort a P/E ratio
1. To invest successfully means you need to buy great companies at attractive prices
2. Investors purchase an asset for less than their estimate of its value and receive a return more or less in line with the financial performance of that asset.
3. Speculators, by contrast, purchase an asset not because they believe it's actually worth more, but because they think another investor will pay more for it some point
4. Being picky about valuation isn't fun. It means letting many pitches go by and watching many stocks run - stock that never met your strict valuation criteria.
Using Price Multiples Wisely
Prices-to-Sales
1. The nice thing about to the P/S ratio is that sales are typically cleaner than reported earnings because companies that use accounting tricks usually seek to boost earnings.
2. Sales are not as volatile as earnings - one-time charges can depress earnings temporarily and the bottom line of economically cyclical companies can vary significantly from year to year
3. The relative smoothness of sales makes the P/S ratio useful for quickly valuing earnings, by comparing the current P/S ratio with historical P/S ratios.
4. The P/S ratio has one big flaw - sales may be worth a little or a lot, depending on a company's profitability.
5. Retailers, typically have very low margins - that is they convert relatively small percentage of every dollar of sales into profits.
6. Don't compare companies in different industries on a price-to-sales basis, unless the two industries have very similar levels of profitability.
Prices-to-Book
1. Compares a stock's market value with the book value (aka SHE or net worth) on the company's most recent balance sheet
2. Legendary value investor Benjamin Graham, was a big advocate of book value and P/B in valuing stocks
3. For service firms, in particular, P/B has little meaning.
4. Another item to be wary of when using P/B to value stocks is goodwill.
5. Goodwill often represents little else but the desperation of the acquiring firm to buy the target before someone else did, because acquiring firms often overpay for target companies.
6. P/B may be low, but the bulk of the B could disappear in a hurry if the firm declares the goodwill as "impaired" and writes down its value
7. P/B is also tied to ROE in the same way that P/S is tied to net margin. Given two companies that are otherwise equal, the one with higher ROE will have a higher P/B ratio
8. P/B isn't terribly useful for service firms, it's very good for valuing financial services firms because most financial firms have considerable liquid assets on their balance sheets.
9. The nice thing about financial firms is that many of the assets included in their book value are marked-to-market in other words - they are revalued every quarter to reflect shifts in the market place, which means that book value is reasonably current.
Price-to-Earnings: The Benefits
1. The nice thing about P/E is that accounting earnings are much better proxy for cash flows than sales, and they're more up-to-date than book value.
2. A company that's trading at a lower P/E than its industry peers could be good value, but remember that even firms in the same industry can have very different capital structures, risk levels and growth rates, all of which affect the P/E ratio
3. All else equal, it makes sense to pay higher P/E for a firm that's growing faster, has less debt, and lower capital reinvestment needs
4. Few questions that can distort a P/E ratio
- Has the firm sold a business or an asset recently ?
- Has the firm taken a big charge recently ?
- Is the firm cyclical ?
- Does the firm capitalize or expense its cash flow-generating assets ?
- Is the E real or imagined ?
Price-to-Earnings Growth (PEG)