Some investors claim value, like beauty, lies in the eye of the beholder. One of us might look at a stock with a price-to-earnings (P/E) ratio of 30 and see a bargain while others see an overvalued stock they’d never want to own. A true value investor might question why anyone besides an index investor would ever own a stock with a P/E ratio of 30. Index investors, of course, must own all of the stocks in the index they track no matter what the P/E ratio is.
Value investors usually look for a low P/E ratio on an individual stock or the broad market for a buy signal. This is the idea behind Nobel Prize winner Dr. Robert Shiller’s long-term cyclically adjusted price-to-earnings (CAPE) ratio. CAPE is considered a measure of valuation and investors following the indicator would have sold in 1992 when the CAPE moved above 20. At that level, it was about 25% above the long-term average of about 16. Market historians noted this was the level seen before bear markets in the early 1900s, 1920s and 1960s.
CAPE provides a warning about the broad stock market so it would have been reasonable to sell all stocks at that time and move to cash. Unfortunately for value investors, CAPE would remain above average for more than 25 years and the S&P 500 would gain nearly 800% while they waited for the next buy signal.
This demonstrates one reason why investors might want to own overvalued stocks. There could be significant gains ahead even though valuations are above their historic averages.
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Another answer to why an investor would want to own a high P/E stock could be that the underlying company’s growth justifies the ratio. The PEG ratio is one way to define whether or not a P/E ratio is justified.
The PEG ratio is a valuation tool that allows to find a stock’s value by assuming the stock is fairly valued when the P/E ratio is equal to earnings per share (EPS) growth rate. This implies a stock with an EPS growth rate of 30% or more should have a P/E ratio of 30.
Let’s assume a company is growing at 30% a year and reported EPS of $1 last year. With a P/E ratio of 30 the stock is trading at $30. EPS come in at $1.30 this year and the stock is still trading with a P/E ratio of 30 but is now priced at $39. Next year, EPS of $1.69 and a P/E ratio of 30 provides a price target of $50.70. Investors who believed the stock was expensive at $30 missed a gain of more than 60%.
Perhaps they bought a stock with a P/E ratio of 10 growing earnings at 10% a year. Assuming a constant P/E ratio of 10, they enjoyed gains of 10% a year. In this case, the bargain was a market laggard.
This problem illustrates the idea of relative valuation. Stocks should be valued based on their expected growth rates and faster growth should carry a higher valuation. However, high valuation stocks are among the riskiest because the stock can crash if the company fails to meet earnings expectations. There is a solution to this problem as well which is to buy a portfolio of stocks offering value on a relative basis expecting some to deliver gains and some to continue lagging the market. The portfolio, on average, is expected to do better than the market average.
Several studies have shown the success of this method including James O’Shaughnessy’s What Works on Wall Street and Richard Tortoriello’s Quantitative Strategies for Achieving Alpha. They looked at relative valuation rather than absolute valuation to spot bargains. But they also look at the performance of a portfolio rather than focusing on individual stocks. They expect some value stocks to be winners while others will be losers but the portfolio is expected to deliver gains.
Individual investors often ignore this approach. They may look for specific values of a P/E ratio or some other fundamental metric on an individual stock. They might want the P/E ratio to be below 15 or the dividend yield to be above 3% or the price-to-sales (P/S) ratio to be below 2. Unfortunately, these numbers may be meaningless.
The right P/E ratio or P/S ratio for any stock depends on a company’s growth rate as we saw with the PEG ratio. Or it could depend on the company’s industry. We would expect a tech stock to trade with a higher P/E ratio than a regulated utility and we would expect a retailer to have a low P/S ratio. Those expectations are based solely on their respective industry norms. Interest rates also have a role in defining the “proper” value of a stock.
For example, investors often look for income. When interest rates on ten-year Treasuries were above 10%, stocks offering yields of 3% looked like poor income investments. When interest rates fell below 2%, a 3% yield looked attractive. This is the basis of rule that stocks should trade at lower valuations when rates are high and stocks should be awarded higher valuations when rates are low.
There are several ways investors can consider valuation on a relative basis.
The PEG ratio can provide insights into the proper level of the P/E ratio. For other metrics, investors can compare the stock’s current ratio to the average of the market or better yet the industry. It’s also best to consider at least two different metrics when looking for value. In some cases, the P/E ratio might not capture a company’s potential. This was the case with Amazon.com (Nasdaq: AMZN) a year ago.
The story with AMZN was cash flow growth. The company was reinvesting free cash flow in the business and could grow earnings later as long as cash flow grows. Many investors ignore cash flow and other metrics and they ignore relative valuation because this data can be difficult to find, interpret and use.
It’s possible to do this with the right data. The P/S ratio can be found for all stocks and the average of that ratio can be found. Or, the values can be sorted into deciles with the lowest 10% of P/S ratios in one group and the highest 10% in another group. This is the method used by O’Shaughnessy and Tortoriello, among others. The problem with this method is that fundamental data for all stocks can be expensive to obtain and then some level of programming skill is usually required to complete the sorting.
An alternative is to find the value for a company you are analyzing and compare that value to the industry average. Data to do this can be found in web pages maintained by Dr. Aswath Damodaran, a well-respected business professor at New York University’s Stern School of Business. His website is at http://pages.stern.nyu.edu/~adamodar/. In particular, the data includes variables such as P/E ratios, PEG ratios and expected growth rates by industry sector along with less well-known variables like value/EBIT and value/EBITDA multiples by industry sector. EBIT is earnings before interest and taxes. EBITDA is earnings before interest, taxes, depreciation and amortization. These multiples are widely used by investment bankers when valuing potential takeovers.
Dr. Damodaran’s data can be used to determine whether or not a company is relatively overvalued or undervalued compared to its peers. This could be the best way to think of valuation since it incorporates the current investment environment and limits the comparison to a relevant group. Using absolute rules can lead to missing years of market gains or missing the biggest gainers like AMZN.