Identifying what a stock is worth is the one of the most challenging problems an investor faces. A stock’s worth determines whether it’s a buy or a sell. If a stock is trading its worth, or below its fair value, the stock has the potential to deliver a gain as the price moves towards fair value. Stocks trading above fair value carry risk that the market price will fall.
Finding a stock’s fair value is the question Warren Buffett’s mentor, Ben Graham, set out to answer in his classic book, Security Analysis. Writing with his partner David Dodd in 1934, Graham laid out techniques for valuing stocks. Their ideas were based on the information they had available at the time. Security regulation was still a new idea in the early 1930s and companies were not required to disclose as much information as they do now. One of the few pieces of information available to an investor in the early 1930s was an earnings number provided by the company. Without disclosures, there was no way to verify the accuracy of the earnings number, but company-reported earnings were a starting point for Graham and Dodd’s valuation models.
Graham and Dodd suggested using average earnings to overcome potential problems with accuracy. By looking at the average earnings over a seven-year period an investor should see how the company performed in both good times and bad. Using average earnings, Graham and Dodd suggested calculating the price-to-earnings (P/E) ratio. Investors could then look at how the P/E ratio varied over time. To make money in stocks, investors should buy when the P/E ratio was low. A stock should then be sold when the P/E ratio was high and the process should be repeated, rotating in and out of stocks based on value.
Graham and Dodd seemed to believe a P/E ratio of about 15 was average and 20 was too high a price to pay for a stock. They recommended selling when the ratio got this high.
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This approach requires trading. Graham and Dodd recognized that stocks will move from being undervalued to overvalued and recommended taking advantage of this. They did not recommend finding one or two stocks to own forever because they recognized the excessive risks in that approach. It was better to sell when a stock became overvalued than to hold that stock while it gave back its gains or consolidated its gains while waiting for earnings to grow.
In addition to using the P/E ratio, investors at that time could also calculate a company’s book value. Graham and Dodd suggested buying when the stock was trading below the book value. Stocks trading at prices below the value of the cash on a company’s balance sheet were also considered a bargain. These stocks would be sold when they moved up in price to trade at their fair value. In their books, Graham and Dodd found a number of these opportunities in the Great Depression but they are relatively rare today.
In later years, investors became more sophisticated but used the same general idea — if a stock’s market price is below its fair value, the stock is a buy; when the market price is above the fair value, the stock should be sold or avoided. More sophistication simply meant the math to determine the fair value became more complex. Over time, a discounted cash flow (DCF) model became the most popular way to value a stock.
This model recognizes that the value of future earnings is less than the value of current earnings because dollars will probably buy less in the future. This assumption is being reviewed as negative interest rates become more common, but for now it is still a widely held belief.
In a DCF model, analysts develop estimates of a company’s future earnings and then make other assumptions to reduce the value of future earnings (by discounting) to today’s dollars. There are usually a large number of assumptions involved in the process, for example sales and costs of sales need to be estimated along with interest rates, growth rates of the company’s earnings, the number of shares outstanding after accounting for buybacks and option grants and the risk premiums investors will assign different industries, among other variables.
With a DCF, the estimated value of a stock can be determined to the penny, but any change in any of the assumptions will lead to a change in the estimated fair value of the stock. Different estimates explain why different analysts assign different price targets to stocks. Data services usually average all of the available estimates and report a consensus price target. When an investor is considering two different stocks, if one stock is trading above the value defined by the DCF model and another is trading below the model’s price, the one trading below the model’s price should be the better value for investors.
An alternative to the DCF model is the PEG ratio. Specifically, the formula for the PEG ratio is the P/E ratio divided by the EPS growth rate. The PEG ratio assumes a stock is fairly valued when the P/E ratio is equal to the estimates growth rate of earnings per share (EPS). When using the PEG ratio, a ratio below 1 indicates a stock is potentially undervalued. Higher PEG ratios indicate stocks are overvalued.
This formula can be rearranged with simple algebra to find the target price (P in the P/E ratio). Fair value for a stock would be the product of the EPS growth rate and EPS. We can use historic or expected numbers, but next year’s estimated earnings and the long-term estimated growth rate are commonly used.
Let’s consider an example using Carnival Corporation (NYSE: CCL). The stock is trading at about $45 and the Wall Street analysts’ consensus target is $57. That value is derived from DCF models. We can use the PEG ratio and multiply next year’s expected EPS of $3.87 by the expected EPS growth rate of 16.1%. This provides a price target of $62.31. This is fairly close to the consensus estimate and confirms the stock is undervalued.
The value of the PEG ratio is its simplicity and its objectivity. The math is simple – just multiply estimated earnings by the estimated EPS growth rate. This provides an objective value, while Wall Street estimates tend to be subjective. Often, analysts will use assumptions designed to ensure a price target is above the current price of a stock. This might be done to help the Wall Street firm win investment banking business from a company even though that is not supposed to happen. It might also be done because analysts don’t usually recommend selling a stock and setting a price target below the current price is an implied sell recommendation. The PEG ratio removes this type of subjectivity when determining a price target.
Given its simplicity, the PEG ratio could be all you need to find undervalued stocks. However, it does not work in all cases. When a company’s earnings are contracting, the estimated growth rate will be negative and the PEG ratio should not be used. The PEG ratio is also not normally the best tool to evaluate income stocks. When a stock is valued for income rather than earnings, other valuation techniques are more appropriate.
When looking for buy candidates, the PEG ratio can provide a starting point. But, remember that when a stock is trading above fair value, value investors including Graham and Dodd recommend selling. While Warren Buffett has popularized the idea that a good stock should never be sold, that rule generally applies only to him. Most of us benefit from selling and moving into stocks which offer better potential rewards.