In one of the previous articles, we discussed the company and stock valuation and how to perform the stock analysis: the price per share is mainly determined by the projected earnings. In this article, this principle of stock valuation will be quantified.
The following formula, given in the book 'Security Analysis' by Benjamin Graham and David Dodd, is widely used on Wall Street to estimate the “fair” value of a stock:
Price = “quality factor” x “projected earnings per share for the year”
The astute reader has probably already guessed that the “quality factor” is nothing more than a forward P/E for the stock. The “quality coefficient” or “multiple” usually ranges from 7 to 30. Forward P/E less than 7 is extremely low and frequently serves as an indicator of undervaluation of the company.
Determining the correct P/E (quality factor) for proper stock valuation depends on a number of factors:
1. The rate of growth of the company. The faster a company grows, the higher the multiple the market rewards it. The principle is often used, according to which the multiple should be equal to the expected long-term growth rate of the company (the so-called long term growth, this is the average growth rate in the next 3 to 5 years). For example, if a company is expected to grow by an average of 20% per year, then the P/E ratio of this company should be equal to 20. Unfortunately, in practice, it is difficult, if not impossible, to determine long-term growth rates.
2. The type of business of the company. Certain industries have traditionally been given higher multiples, and there are industries that the market has always given low rates. For example, software companies usually get a high multiple (15-25 and above), while companies in the steel & iron business traditionally have a lower multiple. Such a difference in valuation is associated with the peculiarities of a particular business - some business constantly requires large capital expenditures and therefore is valued lower, in others, it is easier to grow using the capital that the company generated over the past few years.
3. The financial health of the company. The balance sheet shows what financial shape the company is in at the moment.
4. ''Quality" of the company. There are a few factors included in "quality". They are:
capitalization/size of the company. Large companies tend to get higher multiples than similar small-cap companies because they are considered more stable and less risky.
stock exchange the stock is traded. All other things being equal, “listed” companies, i.e. those listed on the NYSE, NASDAQ and AMEX will receive a higher multiple than those on the Bulletin Board and Pink Sheets. Companies traded on Pink Sheets are not required to report to the SEC and carry the greatest risk which usually results in lower P/E.
stock liquidity. Liquidity refers to the average number of shares traded per day. A company's liquidity affects the multiple that the market gives it: illiquid companies do not receive a full multiple due to the difficulty of entering and exiting a position. But it should be noted that grossly underestimated companies are usually found among illiquid companies. Often, as the market begins to notice an undervalued company, its liquidity increases with price.
quality of the management. This refers to the reputation of the company's management. The share price is primarily determined by forecasts and forecasts are often derived from the mouth of management. Therefore, reputation is of great importance. If the management was overly optimistic about the company's prospects in the past and the forecasts did not come true, then the market will remember this and will treat subsequent forecasts with caution.
5. General sentiment of the market. Alas, there is no escaping the influence of the market as a whole. In a bull market, companies get higher multiples, and in a bear market, accordingly, lower ones.
There are no clear rules determining that such and such a company should have such and such a multiple, calculated according to such and such rules. Determining the correct multiple is more of an art than an exact science. In practice, in order to find out what “correct coefficient” a company should have, they consider similar companies in the same industry and with approximately the same capitalization and look at the value of their coefficient. While there are no exact formulas, the above approach can provide reasonable upper and lower bounds for the “correct” multiple. Of practical interest are situations where the actual multiple is outside these estimates. For example, a company report was released in the light of which the actual multiple was 6, while similar companies have a multiple of 15. In such a situation, there is reason to believe that in a short time the price will rise and the multiple will come in line with multiples of similar companies. The next paragraph will give real examples of how the approach works in practice.
The other part of the stock valuation formula is the projected earnings per share for the year.
Price = “quality factor” x “projected earnings per share for the year”
Here are the main sources of earning predictions for your stock analysis and valuation:
Estimates of analysts. They can be viewed on yahoo.com, nasdaq.com, and other sites. But in most cases, it’s unlikely to find an undervalued company based on analyst estimates.
Press releases of companies. This is a very common source of forecasts. There may be a separate press release with a forecast, or the forecast may be included in the company's report.
Sometimes the forecast is absent in press releases but is given at the conference call. A conference call is a telephone (oral) conference, usually held shortly after the release of a quarterly report, where company management reports on quarterly results and answers questions from analysts and investors. Typically, you can listen to a conference call either over the Internet or by calling a toll-free number. Sometimes the company provides a form to the SEC with the text of a conference call, but in most cases, the information is only available orally. Until 2000, only large institutional investors had access to conference calls, but in October 2000, the SEC passed Regulation FD guaranteeing equal simultaneous access to information for all investors.
Using past earnings data and financial reports. If there are no forecasts at all, then a reasonable forecast can be obtained simply by using past financial statements and approximations of future growth. For example, if the company was growing at 15% for the past few years and it is still in the same healthy position it can be assumed that the next year's growth will be in the same range. You may also combine the past financial information with the investor presentations and other press releases to see if the growth might be accelerating. For example, the company may announce a new big partner/buyer of products, the addition of new locations, etc. You may use this information to forecast likely growth in revenues and profit.
The backlog of orders. These are orders already received by the company, but not yet executed. The backlog, of course, serves as an indicator of the company's future profits. But you need to understand that every order included in the backlog has a scheduled execution time. The execution of the order can be scheduled in the next month, in the next quarter, in six months, or even in a year. In other words, the backlog reports the total amount of outstanding orders but does not say anything about when the orders are scheduled to be filled.
Despite its simplicity, the stock valuation formula actually works in the market. Both professionals and individual investors use it in their stock analysis, stock valuation, and target price predictions.