Stock Valuation Methodology Basics
What is the correct value for a company's stock?
You likely wouldn't expect me to say that the answer is easy, but I will because it is! The correct value for any publicly traded stock is (a drum roll, please!) its current price!
With that behind us, let's move to our next question: how do we know if a stock is expensive or cheap? Again, easy answer: it's never either!
The current stock price is always the correct price, never too high or too low. Same thing when it comes to the market's level: always just right. Always!
You may think I'm just wordsmithing and will soon retract these absurd notions, but I won't. Allow me to explain.
Most of us (including me) were taught that we could boil down successful investing to a couple of time-tested principles:
The first principle is that we should buy good companies and hold them for the long-term.
Indeed, it sounds like common sense.
The second principle is that we should buy low and sell high.
Once again, seemingly sage advice.
So, how do we apply these two pillars of investment logic on a day-to-day basis?
We can't; they are at odds with each other.
Do we ever sell a "good" company whose price is "high"? Do you ever buy a "bad" company when its price is low?
What does it mean to "hold good companies?" As an investor, I suspect "good" means a company whose stock price consistently outperforms the markets. It makes sense; unfortunately, that information is useless because we can only measure it by looking backward.
Does looking back at a stock's past performance tell us anything about how it will do in the future? Of course not. Past performance is no guide to expected future performance.
Our first principle of successful investing leaves us with no guide, and we are left to our own judgment which companies are "good" and "not-so-good." Not much help in keeping things simple.
As for buying low and selling high, this is an area where much research was done. The goal has been to find that critical financial measure (or measures) that tells us if a stock is cheap or expensive.
You are familiar with all this work because the very way we talk about markets, stocks, and valuations is wedded to this research. For example, you'll often hear financial experts talk about a company's price to earnings ratio (the "P/E"). They will make statements like, “it's at an all-time high P/E." These words are used to get your attention, and it works. I mean, "all-time high P/E" sounds scary!
Others appear to raise the bar in the quality of their valuation measures by employing even more sophisticated techniques; valuation measures like discounted free cash-flow models, earnings models, or econometric models are used. Although mathematically more complex, they still suffer in application.
I believe valuation measures are used only to quantify opinion and call it fact. They are bad science.
For any valuation measure to be useful, one thing must be true, and by "truth," I mean a scientifically proven cause-and-effect relationship. For these financial valuation measures to be valid, stock prices and market values must, at some point, be expensive or cheap.
I don't believe they ever are, so I think these valuation measures are useless when making investment decisions. Investing is not about finding cheap or expensive stocks. Nor is investing a process of finding good and bad companies.
Investing is a process of understanding and assessing all that is around us.
Many factors influence investment markets. Just about anything that influences people and their lives impacts markets. We can't boil that down into a single measure. It requires knowledge and perspective.
The current price is always the correct price because the current price is the pure reflection of the market's assessment of all the factors that influence the markets and each company.
In this light, when you start researching a company, your goal is not to render judgment on its value; instead, you want to understand it. You create your work by asking: what is the market assuming to derive today's price? You start by accepting the market knows something, and you want to figure out what that is.
Assume the market is right and figure out what it is.
With this knowledge in your pocket, your investment decisions take on a whole new dimension. You are now looking to buy the stocks where your research gives you confidence that the company will do much better than the current consensus assumes. You'll sell stocks where the projections underlying the current market price look far too aggressive based on your research.
You should also keep in mind that the longer your investment horizon, the more the company's performance will determine your success. Over shorter periods, outside influences unrelated to the company gain a more extensive power.
That's why it's essential to understand the current macro environment and assess what the market expects.
For instance, we see three things to watch as vital macro risks.
Low-interest rates: The market currently (in our opinion) puts a premium on many stocks only due to current low rates. If rates rise, the market is at risk.
Corporate tax rates: The 2017 Federal reduction to corporate tax rates and changes to many onerous tax laws created a multi-year tailwind for U.S. economic growth. If those are changed aversely, it will impact the market.
Pandemic-related shutdowns: States that forced closure on small and service-related businesses are seeing some close permanently. The longer these shutdowns continue, the more companies will fail. There is a tipping point in the number of closures that will impact long-term unemployment after the pandemic ends. The stock market is not pricing in any long-term impact from this.
Successful investing cannot rely on simplistic measures. Investing requires knowledge of the economy, the markets, and individual stocks. You must weigh each of these in light of your time horizon.
At Nicollet, we are engaged in fundamental research encompassing the market and individual stocks. We invest our client's stock portfolios in individual stocks based on that work. If you would be interested in hearing more about how we invest, please give me a call.