Why It’s Hard To Value Stocks
Stock valuation is one of those skills that are subject to interpretation, gut instincts, as well as hard numbers. There is no magic formula and if you only use hard numbers or instincts alone you will likely be disappointed, or worse get crushed by the market.
One way to mitigate stock valuation is to diversify, index, or hand your money over to a money manager. From this point of view, buying a broad based index fund at an overall attractive valuation can be an easier way to investor success. However, at Six Figure we are stocks pickers. Why? Selecting the best stocks offers the ability to get great returns that are better than ETFs. I’ve done it, others have, and you can too.
In this article I will discuss how the market values different types of investments and provide some tips on how to determine what you need to consider to get the valuation process started. To get started, let’s look at how these companies have been valued in different ways by the market over time:
NASDAQ:AMZN – Amazon.com
When Amazon first entered the market, critics said it was incredibly overvalued by any measure you could look at it. They were right, at least for a while. The initial reason why is that Amazon was being compared to other book sellers. If an investor thought of Amazon as just a bookseller, they could never hope to earn their investment back in one’s lifetime. Most investors did not (and perhaps could not) factor in the eventual huge moat and brand created. They have been able to expand into other channels as well as demonstrate exceptional execution in logistics and information management. So, today, the market values this company primarily by its huge revenue growth (earnings are still lagging way behind).
Caterpillar is a Dow Jones Industrial blue chip stocks that manufacturer’s construction and farming equipment. Unlike Amazon the business model is well known and defined. It’s unlikely to create a moat in some other business other than what it has been doing for decades. Caterpillar has a beta almost twice as high as the general market, which means that it is more volatile than the general market because Caterpillar is very much impacted by the economic cycles of the countries it does business.
During economic booms, the stock gets ‘expensive’ because earnings estimates lag actual earnings. Conversely, when recessions occur, the stock becomes ‘cheap’ because earnings estimates fail to predict the fall or lower growth of expected earnings. However, Caterpillar does have the long term economic growth ‘winds’ of the emerging economies at its back.
NYSE:PM Philip Morris
Philip Morris is a proud and exceptionally well managed company that is pretty boring and is unlikely to excite anyone. It’s likely not going to surprise anyone by going into other businesses outside its expertise and the products they sell may increase in sales over time but not like gangbusters which could occur for Caterpillar or Amazon. Philip Morris has made some investors rich, but it didn’t happen overnight.
The result of this is a beta that is less than the market average and a company that provides very consistent returns on equity (the money they make on your investment). Like its parent company NYSE:MO (Altria), it is usually underestimated and undervalued(low P/E) which creates opportunity for out-performance, albeit slowly. They will make money for you year in and year out without much flash or glitz.
Discounting The P/E
In the examples above, if you try to assess each company by its P/E (Price/Earnings), it may be confusing at first why companies that are generally good quality, growing companies could have drastically different P/Es. You need to look at more than just the P/E, you need to determine how Wall Street looks at the company.
Bucket Your Stock
Wall Street likes to put companies into buckets, and here is how they might describe these companies. These terms are often used by analysts and brokers. There is some merit to the terminology but don’t let it necessarily pigeon hole your assessment. Sometimes you can get a leg up by viewing a company differently than the crowd.
In the examples above, Philip Morris is often discounted as a growth play to sexier names such as Amazon. This misunderstanding plus creates an undervaluation situation which has the potential for an out-performance opportunity.
Here’s how Wall Street looks at these companies.
Growth Stock – AMZN is a pure growth play. Revenue growth is most important in valuation.
Cyclical Stock – CAT is a cyclical stock, which means that it bobs and weaves with the economic cycle. Think of that sine wave you learned about in High School. For cyclical’s, earnings momentum during the economic cycle is most important.
Secular Stock – PM is a secular stock, which means that it is relatively immune to the economic cycle and does not exhibit very fast or explosive growth. For secular companies, the fundamentals of the companies revenue, dividend and earnings growth are important.
Back To Earnings
When you want to determine how to value each stock, go back to the basic tenet of valuing any investment: by its earnings. This sounds like an easy task, but as talked about above, pinning down earnings may not be easy. This makes the valuation process harder. This is what we know about each of these investments concerning their earnings:
AMZN – earnings barely exist and have not been fully realized by business model.
CAT – earnings exist but vary quite a lot based upon the economic cycle.
PM – earnings exist and can be counted on like money in the bank.
It’s harder to value a company the less that is known about its earnings, particularly out into the future. This is where the risk/reward trade-off comes into play, this uncertainty can create opportunities for out-performance because you see future profit where others may not.
Stock Valuation Takeaways
When you try to analyze stocks to determine if they are worthy of investment, you need to find out how to value the stock and how much you think it is worth. From this information you can then determine if the current stock price makes it attractive to buy, sell, or hold.
The first step in this process is to research the stock and determine how you think it should be valued.
- Before valuing a company, determine what ‘kind’ of stock it is, the three stocks above offer some examples. But don’t necessarily be beholden to Wall Street bucketing.
- Assess the current economic cycle, if that relates to the company valuation.
- The less that is known about current or future earnings, the more research you need to do on the company and its business model. You will need to use some instinct to help assess the situation.
- A good place to get information is the company itself. Read its 10Ks, and listen to the quarterly conference calls.