DGI Lesson 11: Valuation

May 22, 2014

When evaluating stocks, there is a difference between the value of a company and its price. The purpose of this lesson is to explain the difference between the two.

I will illustrate ways to estimate the fair value of a company so that you can compare it to the market price of its stock. That way you can decide for yourself whether a stock is overpriced, underpriced, or selling for a fair price.

What Is Valuation?

Valuation is the process of determining the current worth of a company’s stock. Valuation is an assessment of the stock’s value as an investment.

If you have ever had a home appraised, stock valuation is similar.

Just as a home appraisal would help you understand whether a home’s price is fair, stock valuation helps you understand if a stock’s price is fair.

The idea is that each stock has an intrinsic value, meaning a fair, true, or inherent value.

You cannot measure intrinsic value with a ruler or gauge. It is not a physical quality.

Rather it is an assessment based on facts and logic.

Reasonable minds can differ over what is the fair value of a stock, just as three skilled and honest appraisers might give you different estimates for the value of a home.

Value vs. Price

In contrast to the range of fair values that can exist for a stock, its price is an exact number that you can look up at any moment. Price is determined minute-to-minute by the stock market.

As I write this, here is Johnson and Johnson’s (JNJ) exact price as shown on Morningstar:

CaptureAs you can see, JNJ’s price was $102.51, and it fell $0.29 that day. Every quotation service, like Morningstar, tracks the price every minute, because stock prices change continually with every trade in the market.

In contrast to JNJ’s constantly changing price, do you believe that JNJ’s value changes every minute? I don’t, and neither should you. Its true value changes much more slowly, as it conducts its business, carries out strategic programs, introduces new products, and so on.

We value a stock so that we can understand how its price relates to its intrinsic value: Is the actual price higher, lower, or about the same as its true worth?

I substitute “valuation” for “price” in almost all of my thinking about stocks. When I read “price,” I think “valuation.” If someone is writing about a “cheap price” for a stock, I want to know why they think it is cheap. Cheap compared to what?

Here’s why to think that way: If all you know about a stock is its price, you do not know whether the stock is fairly valued. Here are two common ways that the concepts are mixed up.

• The fact that a stock has pulled back from a recent high does not necessarily mean that it is well valued. The price may have fallen for an important reason. Maybe the company issued a bleak outlook or suffered a disaster like an oil spill. Or maybe the stock was way overvalued to begin with, and it remains overvalued even after losing a few bucks off its price.
• Similarly, a sudden or prolonged price increase does not necessarily mean that a stock has become overvalued. There may be good reasons for a rise in price, and the stock may still be a relative bargain even though it is selling for more than it was a few months ago.

Valuation allows you to interpret the actual price in light of all relevant factors when you are considering whether to buy, hold, or sell a stock. It takes you beyond simply comparing a stock’s current price to a recent price or to the stock’s 52-week high or low. Those don’t really tell you about valuation.

Why Consider Valuation?

Think of valuation as an interpretation of the actual price. Valuation answers whether a stock is:

• fairly priced, or selling at about its intrinsic value;
• underpriced, or selling at a bargain; or
• overpriced, selling for more than it is worth.

We want to buy stocks in the first two categories and avoid stocks that are overvalued. There are two main reasons.

(1) Better yield

As we saw in DGI Lesson 6: Yield and Yield on Cost, a stock’s dividend yield mathematically moves in the opposite direction of its price. Yield goes up when price goes down and vice-versa. That is plain from the definition of yield:

Yield = 12 Months’ Dividends / Price

So buying at a better valuation (lower price) means that you get a higher yield right out of the starting gate. If you lower the value of “Price” in the equation above, the value of “Yield” goes up.

Assuming that your stock never cuts its dividend, your initial yield is the lowest yield on cost that you will ever experience for that purchase. It’s locked in. A higher initial yield will benefit you for as long as you own the stock.

(2) Lower price risk

Most investors want their stocks’ prices to rise over the long term. If you can purchase a stock at less than its intrinsic value, you are tilting the odds in your favor that future price movements will be upwards. The larger the difference between the price you pay and the stock’s intrinsic value, the larger is your margin of safety that future price trends are likely to be positive.

Nobody can predict the future, but part of being a good investor is putting the odds in your favor whenever you can. Good valuation will not shield you from short-term price declines. Mr. Market moves prices up and down all the time, and you cannot control that.

Nevertheless, knowing that you bought at a good valuation should provide some comfort from the stress of falling prices. You can think of such price drops as short-term aberrations rather than fearsome “loss of money.” You don’t lose any money unless you sell at the reduced price.

Valuation Is Not the Same as Company Quality

Valuation has little to do with company quality. Both lousy companies and excellent ones can be undervalued or overvalued.

Let’s consider overvaluation first. An excellent company can have its price bid too high. Investors may be exuberantly chasing a “hot” company, or perhaps they emotionally overpay when chasing yield. The whole market may be rising as a result of irrational demand for stocks. Those kinds of things happen in markets.

So please remember: No matter how excellent a company is, its price can be too high. When that happens, it probably is not a good time to buy shares in that company.

On the other hand, an excellent company can have its price fall below its true worth. Perhaps the entire market is in a slump, taking all stocks down with it. Or a company may suffer a temporary setback that will make no difference in the long term, but which causes traders to run from the company, causing its price to fall temporarily.

For the long term investor, price drops like that can present buying opportunities for excellent companies.

• Over the long term, the odds are that the highest quality companies will recover faster than the market as a whole. The phenomenon is called flight to quality. If you purchased a high quality company at a good price, you will benefit from this.
• As we have already seen, a price decline causes a company’s yield to increase. If you can buy a dividend growth company at a better price, you are rewarded with a higher yield. Your dollars buy more income.

Four Steps to Valuing a Company

I use a four-step approach to valuing companies. None of them takes very long. I can value a company in 10 minutes, and with a little practice, you can too.

(1) FASTGraphs Method 1

I use FASTGraphs in two ways.

First, I display the usual forward-looking graph and observe which channel the current price falls into.

CaptureJohnson and Johnson (JNJ), which I own, is a superb company. It has one of the few AAA credit ratings in existence, and it also sports low debt. Its earnings are expected to grow at 5% per year for the next few years.

But the graph above suggests that it is slightly overvalued. The orange line represents fair value, while the black line shows actual price. We can see that the actual price is in the second channel above the orange line. To me, that says by this method of determining valuation, JNJ is a little overvalued right now.

On FASTGraphs, the orange line (fair value) is drawn using a price-to-earnings (P/E) ratio of 15. That is the default ratio used by the software. The ratio of 15 (meaning 15-to-1) is the historical long-term P/E of the entire market. Over many decades, investors have been willing to pay 15 times earnings to buy stocks.

JNJ is selling for a P/E of 17.1. That means it is overvalued, if only by a small amount. If we stopped there, we might decide that JNJ costs too much and decide not to buy it.

But I like to use multiple appraisal methods, because just as with home appraisals, different methods can yield different results.

(2) FASTGraphs Method 2

The second method also uses FASTGraphs. By clicking another tab, we can see JNJ’s price compared to its own “normal” P/E ratio instead of to the market’s long-term average of 15.

CaptureNow we get a different picture. The fair value line, now in blue, is drawn at P/E = 20.4. That is JNJ’s average P/E ratio over the past 20 years. It turns out that JNJ, as often happens with high-quality companies, historically has traded at a P/E ratio that exceeds the market’s average.

When you compare the black price line to the blue fair value line on this graph, it is more than one channel under the blue line. That suggests that the stock is undervalued, not overvalued.

(3) Morningstar

The popular investment site Morningstar ranks many stocks using a 5-star scale. Their star ranking stands for their estimate of each stock’s valuation.

Morningstar’s analysts use a different assessment method from FASTGraphs. They use a comprehensive Net Present Value (NPV) approach to estimating fair vlaue. Some investors consider this to be the gold standard in valuing stocks.

A full discussion of NPV is beyond the scope of this article. (See this site for a good basic explanation.) I believe that the NPV approach is valuable, but its formulas are very sensitive to slight changes in inputs. Garbage in, garbage out. So I consider NPV calculations to be instructive, but subject to interpretation, just like every other method of calculating fair value.

Remember the snapshot from Morningstar earlier in this article? Besides showing JNJ’s price, it displayed 3 stars. That is Morningstar’s way of saying that, under its valuation approach, JNJ is fairly valued right now. They use a 5-star scale, and 3 stars is exactly in the middle of that scale. Three stars = fair value under Morningstar’s approach.

(4) Stock’s Current Yield vs. Historical Yield

Finally, I compare each stock’s current yield to its historical average yield.

This is yet a different approach to valuation. The idea is that over long periods of time, the market will tend to price a stock so that its yield stays within a typical range for that stock. The closer you are to the top of this range (i.e., the higher the yield), the more desirable the stock is at today’s price.

If the yield falls toward the bottom of the historical range, it is likely that the stock is overvalued. History suggests that you will be able to get it at a better yield if and when the market brings the price back to a more normal valuation for that stock.

Here’s what I mean. The following chart shows JNJ’s dividend yield over the past 10 years.

CaptureI just do an eyeball test. JNJ’s yield has varied between about 1.75% and 3.75% over the past 10 years. It is currently almost exactly in the middle of that range. That suggests that JNJ is about fairly valued right now.

Putting It All Together

For each of the four steps, I assign a simple score of 1-5 points according to the following table.

CaptureI add up the points from the four methods and divide by 4 to get the average score. Johnson and Johnson scores like this:

• FASTGraphs 1: Overvalued = 2 points
• FASTGraphs 2: Undervalued = 4 points
• Morningstar: Fairly valued = 3 points
• Yield to historical yield: Fairly valued = 3 points

The average is 12 / 4 = 3 points. So I conclude that JNJ is fairly valued. It could be worse, and it could be better.

For a high-quality company like JNJ, I would be willing to pay its current price to buy it. Many dividend growth investors – myself included – are willing to “pay up” for a really high quality company. Bargain prices are even better, but they are often hard to find for the best companies.

Five Takeaways from this Lesson

1. Valuation is a way to determine whether a stock’s current price is fair, a bargain, or priced too high.

2. Different valuation methods yield different results. It is a good idea to use several valuation methods and average them or compare them so that you understand a stock’s valuation.

3. If you can get an excellent company at a bargain price, you benefit in two ways. You get a higher yield, and you improve the odds that its price will not hurt you over the long term.

4. Using tools available on the Internet, you can derive valuations from several methods in just a few minutes.

5. Just because a stock’s price has dropped recently does not mean that it is a bargain, and just because its price has risen recently does not mean that it is overvalued. Use valuation rather than price comparisons to determine what true value is. Don’t make the mistake of thinking that price equals value.

– Dave Van Knapp