Valuing Stocks Using Relative Valuation
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A key part of business is not only determining what to sell (what type of products or services) but also how much to sell those products or services for. If you price your goods too high, no one will buy them! On the other hand, pricing your goods too low may have you leaving money on the table, and possibly not even covering your expenses.
There are generally 3 primary methods for determining a price for the product or service you might sell:
- Cost-based Pricing - determine how much it costs to produce the product or service and tack on a bit of profit (margin) to get to the final price.
- Competitive Pricing - if you have a product or service that is similar to what other companies are making, charge a similar price for your goods.
- Value-based Pricing - what is the value to the end-user? How much are they willing to pay? This can be extremely tough to determine sometimes, especially if you have a fairly new or unique product/service.
Along the same line, understand that all investment markets (stock market, real estate market, bond market, etc) are driven by supply & demand factors just like consumer markets. Stocks, bonds, and real estate tend to fluctuate in value because investors are constantly trying to assess the real value of the assets in their respective asset classes. The more people are buying a particular asset reflects high demand, driving the price up. The more people are selling a particular asset reflects lack of demand (and excess supply), driving the price down. And different people will place a different value on things based on a number of factors like economic conditions, financial situation, need versus want, etc.
Many investors versed in finance and valuation techniques attempt to value an investment by conducting a bottoms up valuation analysis. The value investor attempts to do a deep-dive analysis into a company's financial statements to determine its intrinsic value, the underlying worth of the company. This is based on how performance is projected to be in the future. They then discount that to a present value while scouring the market for opportunities priced below that intrinsic value. The intrinsic value of any investment is the discounted present value of its future cash flow.
Makes sense doesn't it?? People are buying and selling stocks and other investments at high frequency, driving the price of those investments up & down. But price doesn't necessarily reflect value, as different people/organizations will value an asset differently based on a number of factors. But if you can adequately assess the intrinsic value of an investment and then catch an opportunity to buy at a price below that perceived value, you've got a deal!
Attempting to analyze and assess the intrinsic value of an investment is a very complex and ambiguous process. The 2 most common approaches are the DCF model (discounted cash flow method) and the Dividend Discount Model. While I am personally very well-versed in these methods, they go beyond the scope of this blog, so I'm not going into detail on them. Again, these processes can be very complex and also fairly mechanical, involving a good deal of number-crunching. It's also the case that they can be sufficient for some investments while not working so well with others.
Use Price-Relative Methods: quick & easy, to-the-point...
Fortunately, there are more straightforward and intuitive approaches to valuing a business. Fortunately too, they're fairly quick & easy to use!
Below are common shorthand techniques usually used in conjunction with a DCF or DDM valuation analysis, but they can also be very effective on their own in providing insight on how much an investment costs versus how much it's worth (i.e., how much it's earning). The assumption is that the price of a share of stock should be directly linked to a given performance characteristic of the company, such as earnings per share or cash flow.
The P/E Ratio
With respect to stocks, the P/E ratio is widely used and cited in investment circles, and it's usually highlighted in a company stock's main investment profile. Visit finance site such as Yahoo Finance, Google Finance, or your broker's site, and you'll find the P/E ratio detailed on any company's main profile. It's simply a ratio that divides the price (P) by the net earnings (E) and quoted in per share terms. The level of earnings will vary across companies, so establishing a ratio is a meaningful way of gaining perspective on a particular investment's price relative to the investment's ability to earn (i.e., relative to the investment's underlying value). As we know, historic earnings are important, but future earnings are key to receiving an adequate return on investment (ROI). So, if possible, you'll want to ensure you're looking at projected future earnings (i.e., a future P/E ratio) to assess value.
So if Starbucks stock is selling for $98 per share and projected earnings are $2.89 per share, then the P/E ratio would be 33.98, as depicted below in the screenshot from Fidelity Investments.
The real value of using the ratio comes not in the form of the resulting number itself, but in comparing the ratio to the same figure of other companies during the same period, competitors within the same industry such as, for example, McDonald's or Wendy's in the case of Microsoft. What is the relative value? How does Starbucks' P/E ratio compare to that of McDonald's, Mondelez, or other competitors, as well as the average ratio of peers in its industry as a whole? If it's lower, that would suggest the possibility that Starbucks' stock is selling cheaply relative to its competitors. We're always looking for a deal, and it's important to buy in at attractive prices!
Going to the "Comparisons" page within the Starbucks quote on Fidelity, I can see a comparison of certain metrics, including the P/E ratio, to other related companies. In this case, the data is based on figures from the prior day, and Starbucks' P/E ratio is at 28.27, well below the industry average of 100.7 but slightly higher than McDonald's. So, right about now, it can be said that Starbucks stock is slightly more expensive with respect to earnings power relative to McDonald's.
Without getting into too much complex detail, it's the same concept as the competitive pricing approach for pricing a product or service mentioned above. If I'm going to pay $98.27 per share for a company earning $2.89 per share, let me create a ratio to fairly compare against other such companies. Just remember to bake in what Ben Graham referred to as a "margin of safety" to ensure an attractive price. And, of course, be sure to do your homework in all respects before investing. Refer back to my post "My Core Investing Principles" for more info.
Other Price-Relative Ratios
I would recommend always compare an investment opportunity's pricing to that of it's peers. These ratios can be very useful in that regard. If you're buying real estate, for example, you look at the price you're about to pay for the property, but you also have an appraisal done that compares that real estate to comparable pieces of real estate (i.e., property with similar features in terms of size, # of rooms, location, etc). Likewise, do a similar comparison with stocks, bonds, and any investment to help aid with the price you're willing to pay for the investment's projected return. Always compare apples to apples, and oranges to oranges.
The following ratios also aid in determining the value of a stock by relating share price to cash flow, sales, or book value.
- Price-to-cash flow (P/CF) ratio - provides a more accurate picture of a company's earning power. "Net Earnings" include non-cash accounting items such as depreciation and amortization....and we all know cash is king!
- Price-to-sales (P/S) ratio - this is a good measure to use for brand new companies that may have little-to-no earnings. Companies just starting out may be operating without a profit for a while, so a useful metric is sales, and a ratio comparison using P/S is very helpful. As a rule, I never invest in an unprofitable company though. It can also be helpful in valuing more established companies as well.
- Price-to-book value (P/BV) ratio - the book value of a company is simply the figure resulting from Total Assets minus Total Liabilities. It gives a true worth of the company on paper.
*The EV-to-EBITA Ratio*
As mentioned, the P/E ratio is widely cited and used, so it's generally a quick & easy tool to discover and utilize. For more sophisticated investors, I would also recommend the forward-looking, enterprise value-to-EBITA multiple (EV-to-EBITA) which improves the simple P/E multiple in 3 ways:
- It strips out nonoperating items
- It eliminates the effect of different capital structures across companies being compared
- Using projected forward earnings more closely aligns the level of earnings over a company's business cycle.
EBITA stands for earnings before interest, taxes, and amortization. Sometimes this figure may be quoted within financial metrics and other times it may require digging into the financial statements and making the proper calculations.
Identify excellent opportunities to invest in. Focus on the company's long-term economics, operating history, and any competitive advantage present. Then use Price-Relative methods for a quick & easy approach to try and identify whether the investment is reasonably priced, possibly selling at a discount, or overvalued.
Use multiples such as P/E, P/S, and P/BV with caution though. Done properly, relative valuation using multiples can provide useful insights into a company and its valuation. However, that step is just one aspect to consider before making an assessment of a company as an investment. It's always best to do a well-rounded analysis to ensure you're comparing companies on a comparable basis. Make comparisons across companies within the same industry and with similar levels of performance.
Always remember too that financial analysis is not an exact science. You can leverage data from a company's financial statements or other sources, but never overlook certain qualitative factors that are not so easily analyzed with numbers, such as management capabilities, the nature of the business, and the presence of any competitive advantage. It can be more difficult to assess these characteristics, but oftentimes, these are the driving forces behind a company's intrinsic value!
The information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions. I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP. The contents of this site and the resources provided are for informational and entertainment purposes only and do not constitute financial, accounting, or legal advice. The author is not liable for any losses or damages related to actions or failure to act related to the content on this website. I also may own stock in all of the aforementioned companies.