Value investing is a proven investment strategy capable of producing above-average long-term returns at reduced levels of risk. However, it is a challenging strategy for many investors to implement and follow because it requires the willingness to accept two common short-term realities that typically create attractive valuation.
The first reality that successful value investors accept and recognize is that attractive valuation usually occurs when an individual company is currently out-of-favor. Additionally, there are times when a given company is justifiably out-of-favor due to short-term operating challenges. On the other hand, it is also quite common to see the market overreact where stock price drops significantly farther than operating issues would rationally dictate. When this occurs, a true long-term investment opportunity manifests. But unfortunately, many investors lack the long-term foresight to take advantage of the opportunity.
This leads me to the second reality that successful value investors accept and recognize. The truly accomplished value investor recognizes that short-term stock price action can be, and often is, irrational over the short term. The stock market is an auction, and just like any other auction, people are continuously willing to offer bids or asking prices on a minute-by-minute or hour-by-hour basis. This behavior is dominated by short-term oriented day traders that see the market analogous to a casino.
Ironically, this active short-term oriented approach to stock prices simultaneously represents both a tremendous benefit as well as a significant short-term risk. The risk of course comes from the volatility that is created over short periods of time which stimulates strong emotional responses and often doubts. Of course, the primary emotional responses are fear and greed. Personally, I consider both of these emotional responses dangerous to long-term financial security. However, I also consider fear to be the more dangerous of the two.
The benefit that comes from active day traders is the liquidity they provide all investors. In my opinion, one of the greatest advantages of investing in publicly-traded stocks is that they are liquid. Therefore, if and when I do have a need or reason to withdrawal money from my portfolio, the market accommodates. I may or may not like the prices that the market is currently providing, but if I am willing to accept them, I can have access to my money almost immediately.
The simplest and most effective way that accomplished value investors have learned to deal with these two challenges is by focusing on fundamentals first and foremost. In other words, accomplished value investors ignore price action when doing their analysis by focusing on earnings, cash flows, dividends and other important fundamentals such as balance sheets, income statements and cash flow statements. Simply stated, they understand the importance of analyzing the strength of the business without any regard to its current market price.
To be clear, the price of the stock and the valuation it represents will ultimately drive the decision to buy, sell or hold. However, the company’s stock price and its relative valuation will be the last consideration that the accomplished value investor takes into consideration. Stated more simply, the accomplished value investor focuses first on fundamentals with the objective of determining what they believe the business is worth intrinsically. Once that is finished, and only after that is finished, will the accomplished value investor bring stock price into the equation.
These are the primary reasons why we designed the F.A.S.T. Graphs™, fundamentals analyzer software tool, with the functionality to take the stock price off of the graphs. This empowers the user to evaluate the business devoid of the emotional response and contamination that short-term stock price action typically causes. This may seem simplistic to some of you, but I can state with absolute certainty that I personally always approach the analysis of any company by first taking stock prices off of the fundamental graphs.
Admittedly, since I have seen where the stock prices are before they have been removed, I am not completely ignorant to how the market is currently valuing the business. However, this simple action of removing stock price allows me to focus more clearly and completely on the fundamental merits of the business. By going through this simple exercise, I can generate a comprehensive fundamental assessment of what I have determined the intrinsic value or worth of the business I am analyzing is. This is where the confidence to be “greedy when others are fearful” comes from. In short, I trust the fundamental strength and attributes of the business I am examining more than what an emotional market may be currently assessing it at.
But perhaps most importantly of all, once I have completed the process of determining the intrinsic value of the business, I never let short-term stock price action alter my view. I understand that stock prices are pathological liars and cannot be trusted. Personally, I would never seek out a pathological liar for advice and guidance on any subject. On the other hand, deterioration in fundamentals will cause me to reassess my valuation. However, my reassessment will not be influenced by the price rising or falling over the short run. Instead, my focus will turn towards determining whether the fundamental deterioration represents a permanent impairment of my capital, or simply a temporary and solvable interruption in attractive long-term business prospects. I would sell the former, and buy the latter.
The 3 Phases of Valuation
One of the most important valuation metrics that I often write about and discuss is the P/E ratio. I often point out that a current P/E ratio of 15 as a general rule represents sound valuation for most companies. The only exception to my P/E ratio of 15 valuation measurement would be with companies that are growing very fast. High-growth stocks are worth a higher P/E ratio valuation, because due to the power of compounding, they would generate significantly larger amounts of future earnings than the average company growing at lower rates is capable of. However, and this is critically important to understand, a current P/E ratio of 15 represents only the first of the 3 important phases of properly assessing fair value.
I consider a current 15 P/E ratio relevant as an initial fair valuation measurement for several valid reasons. In other words, I do not consider a P/E ratio of 15 as an arbitrary valuation measurement. Insight into the relevance of the 15 P/E ratio comes from understanding and recognizing the current earnings yield it simultaneously represents. As I will next illustrate, I do not believe it is a coincidence that the long-term historical returns that common stocks have produced on average correlate very closely to the earnings yield that a P/E ratio of 15 represents. Nor is it a coincidence that the historical normal P/E ratio of the S&P 500 falls within a range of the P/E ratio of 14 to a P/E ratio of 16 (P/E ratio 15 average).
The current earnings yield formula is simply the inverse of the P/E ratio, which would be reflected as E/P ratio, or earnings divided by price instead of price divided by earnings. A shortcut method of calculating current earnings yield is to simply divide the number 1 by the P/E ratio. Therefore, a P/E ratio of 15 equals an earnings yield of 6.67% (1/15= 6.67%). The higher the P/E ratio, the lower the current earnings yield. For example, a P/E ratio of 20 represents a current earnings yield of only 5% (1/20= 5%). A P/E ratio of 25 represents a current earnings yield of only 4% (1/25= 4%) and so on.
The current earnings yield ratio basically tells you, “If this stock were a bond, how much would it earn as a percentage of my investment based on this year’s current earnings?” Once again, it is the inverse of the price-to-earnings ratio, or P/E ratio as it is more commonly known. Stated more simply, the current earnings yield is an easy way to evaluate how much return a company’s current earnings power is providing you if you invest in it. This calculation is metaphorically considering the percentage return your money would be earning if you owned the whole company and were entitled to all of its profits.
Obviously, as an investor you want the company’s profitability to generate you a return that is acceptable relative to the risk you are taking through investing your capital. The higher the current earnings yield (the lower the P/E ratio), the more attractive the valuation you are paying to buy those current earnings. This is important because at the end of the day as an investor in a business, your total compensation is subject to the earnings power of the business. In short, investors in a business are buying earnings power. Both future capital appreciation and dividend income will be sourced from the company’s ability to generate future profits.
To summarize, the importance and relevance of the first phase of valuation based on a company’s current P/E ratio is to understand that it only represents the beginning of a more comprehensive valuation assessment. In this regard I look at it as essentially a screening tool. If I come across a company I like very much, but discover that it is being valued at a P/E ratio above 15, I will temporarily pass on further research and due diligence until it becomes more reasonably valued. However, I might place this company on a watch list where I am on-the-lookout for a better entry point. Phase 1 of a comprehensive valuation effort is a reasonable current P/E ratio. Phase 1 is assessing a company’s present or current valuation.
Phase 2 focuses on examining and analyzing a company’s historical operating history and normal market valuation levels. Phase 2 entails learning as much as we can from the past about the company being analyzed from its historical operating history, growth rate achievements and how the market has normally valued those results.
Importantly, phase 2 is executed in order to determine whether or not a company is maintaining its growth, reducing its growth or accelerating its growth. This process requires analyzing a company’s history over numerous historical timeframes. What we are primarily looking for here are trends and/or changes in those trends. Additionally, up to this point we are attempting to relate historical norms to present valuation in order to give us a perspective of what we might expect with an investment in a respective company. However, the completion of phases 1 and 2 do not fully prepare us to make a final buy, sell or hold judgment.
Phase 3 is the final, and I contend most important step in properly assessing fair valuation and entails making reasonable forecasts of what the future may hold for the company in question on an operating basis. At this point it’s critical to understand that forecasting the future specifically relates to making assumptions about the company’s business prospects and not a forecast of what the stock price might do. However, this phase 3 process derives its confidence from the notion that if the investor can assess future operating potential within a reasonable degree of accuracy, then stock price will surely follow. This supports the principle that long-term fundamentals are more important than short-term price action.
To summarize the 3 phases of valuation, the accomplished value investor is analyzing the past, present and future prospects of any stock they are interested in investing in. Although each phase is essential towards making a comprehensive valuation assessment, the third and final phase is most relevant regarding what your future return potential might be. We learn from the past, calculate the present and make our best forecasts about what the future might hold. At the end of the day, future returns from both capital appreciation and dividend income will be functionally related to the valuation you pay to buy future earnings relative to the total amount of future profits (and dividends, if any) you will receive.
Ryder System, Inc. (R)
The analyze-out-loud video associated with this article will evaluate Ryder System, Inc. utilizing the 3 phases of valuation presented above.