How do you interpret the differences in valuation between different time frames on the graphs? (last update 05/12/2014)
Example: GOOGL on an 11 year graph has a P/E=G valuation on 12/31/2013 of $655.10 and appears undervalued, but on the 6 year graph a P/E=G valuation on 12/31/2013 of $398.65 and appears overvalued; is it overvalued or undervalued?
There are several components to the answer, but we will try to be as brief as possible. First of all, F.A.S.T. Graphs™ are designed as a “tool to think with” that helps the user analyze a company over various timeframes. As such, F.A.S.T. Graphs™ does not “say” that a company is over or undervalued but rather reveals information about a given business. In this context, the graphs are dynamic in that they recalculate the earnings growth rate over each time period drawn. Simply stated, this allows the user to learn if a company’s growth is accelerating, decelerating or remaining constant.
Your example, Google (GOOGL), is an example of a decreasing EPS rate of growth. Also, you can see how the market has historically valued the business. With Google the 11-year graph shows that price tracked earnings reasonably well in the first few years of being a public company but has since been below the orange line. In this case, the orange line defaults to a P/E ratio of almost 30 to mirror the company’s growth rate. However, beginning in 2008 you can see that Google’s rate of growth began to slow down a bit. This can be observed by looking at the year-over-year changes at the bottom of the graph.
Thus the compound rate over the entire period of the 11-year graph is about 30%, but more recently this growth has slowed down. When you look at the 6-year graph you would observe a growth rate of about 18% and thus the P/E defaults to this number on the shorter graph. At the time of this answer, Google had a P/E ratio around 22 and thus it would appear under the 30 P/E provided by the 11-year graph and over the 18 P/E provided by the 6-year graph. Sometimes you may need to run various timeframes to find a chart that makes sense – and in doing so you can observe if the company’s growth has accelerated or decreased along with the applicable valuation (normal P/E ratio) that the market has placed on the company.
The point is not to make the graph fit, but instead to try to ascertain a value metric that makes sense and that you would be willing to consider rational. Another point that relates is that historical graphs help you determine how the business has performed on an operating basis, and simultaneously, how the market has treated this historical performance. However, the interpretation is up to the user to decide how to treat this knowledge.
Most importantly, in our opinion, the forecasting graphs (estimated earnings and return calculator) should be given more weight in the research process. If you disagree with the consensus, you can override and put in your own estimate. You learn from the past, but you invest in the future. The history gives evidence of the price and earnings relationship; therefore, future results should work out accordingly, relative to what future earnings do.
Next let’s move to the formulas used for valuation. In the Google example, both the 11-year and 6-year graphs use the P/E = Growth rate formula. This formula is utilized by fast-growing companies (quicker than 15% per annum) and is meant to provide a proxy of valuation. For slow growing companies (5% or less per year) we utilize the updated Ben Graham formula which is marked “GDF” (Graham Dodd Formula). Finally, many companies tend to grow between 5% and 15% each year. For these companies we use a modified formula between the Graham Dodd and P/E = G methods marked as “GDF…P/E=G” – which defaults to a P/E of 15.
Finally, allow us to focus your attention on the normal PE: it is drawn to provide a reasonable proxy for historical valuation when the graph might be odd looking. At the end of the day, F.A.S.T. Graphs are designed to dynamically provide essential fundamentals at a glance.