About two weeks ago, I sent an email to my subscribers asking them what they struggle with. The goal was to create one-on-one discussions with my readers. I was surprised to receive over 300 emails in the same week! Amongst the many replies, one struggle surfaced most often: How can you find the real value of a stock – especially in an overheated market like this one?
In Other Words… When Should I Buy a Stock?
Investors are not born geeks with the incredible urge to spend hours calculating the intrinsic value of companies. They don’t crave the moment they will spend their Sunday afternoon to determine if Walmart (WMT) is worth $75, $80 or $90.
What investors want is to make the right purchase at the right price. This makes sense as the less you pay for a stock, the quicker you make money with it. But in order to know when to buy a stock, the first step to do is to know how much the stock is worth.
When you think about it, it’s the same thing as buying a TV. If you know how much the new Samsung 70″ is worth, you know when it’s time to buy it on sale and you don’t need the vendor to tell. You know because you know the intrinsic value of the TV.
Unfortunately, appraising the fair value of a company is not that easy. You can’t simply run a search through internet and find 4-5 comparables at different stores to make up your mind about how much it’s worth.
A Classic and Almost Too Easy Way to Value a Stock
At first glance, you can determine how much a stock worth by looking at its P/E ratio. Note: this seems basic for most investors, but I need to start with this simple step before I go on with further explanations.
The P/E ratio stands for “Price to Earnings Ratio”. In other words; how many times will you pay for the earnings of a stock. If a company makes $1 per share and it’s traded at $15, the stock is trading at a 15 P/E ratio. The historical S&P 500 P/E ratio is around 16 to 17. This means that you usually pay 16 to 17 times the current earnings of a company. The point is to buy the stock today in the hopes it will continue to grow and that the company will make at least this amount of profit in the future.
When you see companies trading at 30 or more P/E ratio, it usually means that important growth expectations are priced into this company. Facebook (FB) which currently trades around 96 P/E ratio is a good example.
Buy triggers using the P/E ratio are pretty straightforward. By looking at the current industry P/E ratio (the company’s competitors), you will get an idea of the average P/E your stock should trade at. You can cross reference it with the historical P/E ratio of 16-17 (note that some industries are completely disconnected from the historical average and can show lower or higher P/E without telling you it’s a bargain). If all stocks are trading around 16 P/E ratio in a specific industry and the company you are looking at is trading below this valuation – there you go with your buy trigger!
Unfortunately, there are many problems associated with the usage of the P/E ratio. It can’t be that simple, right? Here are some things to keep in mind when you use the P/E ratio as a method of valuation:
#1 The way earnings are calculated can lead to confusion (exceptional profits or loss, future potential or decline in the industry, etc)
#2 When the market is down, all companies seem to be bargains (but some of them will crash and burn during the recession)
#3 When the market is up, all companies seem overpriced (but some of them will continue to find growth while others will crash and burn… again!)
#4 The P/E ratio can change drastically upon new financial results – this is a current valuation of the company not always telling you about the future.
Forget about Easy – Apply a Real Math Model to Assess Value
If you are comfortable with math and enjoy playing with numbers, there are various mathematic models used to determine the real value of a company. The point is to use the current numbers you have on hand while projecting them into the future. The most popular model to assess dividend stocks is the Dividend Discount Model. In two lines, the model calculates the current value of all future cash flows (e.g. dividend paid) generated by a company. This makes tons of sense since dividend investors want to know the current value of a company that will pay future dividends. If you want to dig into a longer explanation of the Dividend Discount Model, I suggest this article written by Matt @ Dividend Monk.
Some investors will also add the Margin of Safety concept to their calculations. The margin of safety is used to create a buffer between the intrinsic value you have calculated and the possible chance of making a mistake in your calculation. Yeah I know… we are already pretty far now in the geek world and I’ve probably lost the ambition of 80% of beginner investors by this point.
But there is more! Advanced investors use various existing models and mix them with their own theories and investing strategies. They usually combine various calculation methods and build huge excel spreadsheets that can attribute a value or a score for each method. A good example is Dividend 4 Life Pre-Screen Model. I’m not going to go into the details of his approach and I’ll let you check it out.
Calculations Take Time; But I Can’t Go Wrong with Them… Right?
Regardless the model you use to determine the value of a stock, you will always find someone that says your method ignores an important factor…. Or gives to much weight to another. But this is not the worst part.
Your calculations are as good as your guesses will be. The problem with all models is that it requires human input. It requires YOU to estimate what returns you expect, how the company should grow its cash flows in the future and how the market will react with new data. If you are using the Dividend Discount Model and expect a 5% dividend growth and the company cuts its dividend 4 years later due to an unexpected event – do you think your valuation will still stand?
I don’t want to offend anyone and here’s my opinion about stock valuation models: they are not worth my time. Since the chances of using the wrong assumptions are very good, I don’t know why I would spend hours doing all kinds of calculations for all kinds of stocks to build my portfolio. In fact, if you start using valuation models, you will have to run your calculation each time the company issues new financial results to make sure it’s not the right time sell (or even buy more!). Therefore, you will be stuck in an endless spiral of calculations. Some people like that and they are very good and successful with it. I say good for them; I’m not this kind of investor.
If I Despise All Stock Valuation Calculations – What Do I Do?
Some people find my method too simplistic or even naïve but I don’t like big calculations in a world filled with unexpected events. The economy is moving faster than a break-dancer and you expect to be able to calculate its next move? I don’t buy that.
I’ve come up with my own way of building and managing my portfolio. It includes my own way to determine if I should buy a stock or sell it. I’ve created a simple but effective way to invest. It took me years, but I’m finally happy with the way I invest and the returns I’m making.
I’ve shared most of my strategy within this blog but if you want a shortcut and save yourself hours of reading, I suggest you check out my special dividend project and register to my exclusive mailing list. I’ll be launching my project in December – so hurry up 😉
Way to go Mike! Even brokers I know do not bother with those complicated models. Long term dividend investing is not complicated. Can’t wait for your project!
Dan Mac @ Dividend Growth Stock Investing
While I agree that the complicated models for valuing companies is a lot of work and most people don’t want to do it, I believe it is important to learn and understand what exactly is being done with those models.
Many people just want to be told when to buy and when to sell. Unfortunately those people are the first to complain about the stock market and being screwed by Wall Street when prices go down.
This is because they don’t have a true understanding of how investing, valuations and financial performance really works.
I think having an understanding of valuing companies is important. Then you can come up with shortcuts to help with your own portfolio buy and sell decisions such as quickly looking over P/E’s, EPS growth, dividend growth.
First time on your site. Very Interesting information, Will keep reading and thinking!!!! My investing stragity used to be buy Blue Chip stocks that produced a dividend and sit back, Have sold out my Portfolio last year into mutual funds, for my wife incase something should happen to me. I am still playing the game of investing on a smaller scale with smaller amounts, Cheers Bill G,