DGI Lesson 11: Valuation

When evaluating stocks, there is a difference between the value of a company and its price. In this lesson we want to understand that difference, and then demonstrate methods by which you can estimate a stock’s value.

Once you know a stock’s value, you can compare that value to its actual market price. Then you can decide for yourself whether the 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 or appraisal of what the stock is worth 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 seller’s asking price is fair or too high, stock valuation helps you understand if a stock’s price is fair, too high, or a bargain.

The idea behind valuation 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.

Warren Buffett has said, “[I]ntrinsic value is an estimate rather than a precise figure….Two people looking at the same set of facts…will almost inevitably come up with at least slightly different intrinsic value figures.”

Value vs. Price

In contrast to the range of fair values that can exist for a stock (depending on who appraised it), its market 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:

As you can see, on that day JNJ’s price was up $0.22 about 40 minutes after the market opened. Every quotation service, like Morningstar, tracks the price continuously, because stock prices change with every trade in the market.

In contrast to JNJ’s constantly changing price, do you believe that JNJ’s intrinsic value as a company changes every minute? I don’t, and neither should you. Its true value changes 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 intrinsic value?

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 earnings 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 its 52-week high or low. Those don’t really tell you about valuation.

Why Consider Valuation?

Valuation gives you a reference point to answer 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.

You can see that inverse relationship on any graph that plots yield and price on top of each other, such as this one:

JNJ’s price and yield are practically mirror images of one another. When price goes up, yield comes down, and vice-versa.

In the short 6-month timespan covered by the chart, JNJ’s yield varied by about 0.6%. That’s a significant difference when compounded over many years of ownership. If you’re investing for cash flow, you would much rather buy JNJ when it’s yielding 2.9% than 2.3%.

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 your income stream 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 gap 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 from that company than they would if you paid a higher price.

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

In this first step, I compare the stock’s valuation to the historical average valuation of the market as a whole.

I use FASTGraphs in this step, specifically the “Forecasting Calculators” that are a short scroll down from the main graph at the top of the page. FASTGraphs plots Price-to-Earnings (P/E) ratios on the same chart as price itself. The comparison between the two is enormously helpful in visualizing valuation.

FASTGraphs allows you to turn some portions of the display on or off. Here is an example of the graph as it appears with all features turned on:

I used to use this display, because the “channels” created by the blue and orange dashed lines were handy indicators of valuation. In this display, Starbuck’s price (the black line) is in the 5th channel above the fair-value reference line (heavy orange line). That suggests that Starbucks is extremely overvalued.

Nowadays, I usually turn off all the display features except for EPS and price. This eliminates everything but the heavy orange and black lines. I like the cleaner look, and I still have all the information needed to assess the stock’s valuation.

I use the stock’s actual P/E ratio (circled in blue) to calculate the degree of overvaluation or undervaluation.

Here’s how to do it. The orange line is drawn using a P/E ratio of 15. That’s the historical long-term P/E of the stock market itself, which is used  as a “fair value” reference line.

The black line shows the stock’s actual price.

In this example, Starbuck’s actual P/E at its current price is 22.0 (circled in blue). We use that to calculate a simple valuation ratio:

Valuation ratio = Current P/E / Orange-line P/E

Valuation ratio = 22.0 / 15 = 1.47

The valuation ratio tells us that Starbucks is overvalued, because its actual P/E is way higher than the reference value of 15. More specifically, it suggests that JNJ is overvalued by 47%, because 1.47 is 47% higher than 1.

We can use the valuation ratio to calculate a fair price for Starbucks.

Fair price = Actual price / Valuation ratio

Fair price = $52 / 1.47 = $35

Starbucks is trading for $17 more than its fair price. It’s far overvalued as estimated by this first step.

Note that I round off dollar figures to the nearest whole dollar. I do that to reinforce the idea that valuation is an estimation or assessment process. There’s no use introducing false precision into it.

When I do valuations, I use the degree of overvaluation or undervaluation to rate the company on each step. I use 10% “zones” above and below fair price to characterize its valuation.

As you can see, my “fairly valued” band is wide: +/- 10% of fair value in either direction. Again, that is a way to avoid presenting a picture with false precision.

In Starbuck’s case, using this first step, the stock is in the red zone, meaning extremely overvalued.

But wait, there’s more.

Step 2: FASTGraphs Method 2

In this next step, I compare the stock’s price to its own long-term average P/E ratio.

This step “normalizes” the valuation estimate: It’s based on the stock’s own long-term valuation instead of the market’s long-term valuation that was used in Step 1. The idea is that some stocks “always” seem overvalued, usually because they are expected to have fast profit growth. Others seem perpetually undervalued, usually because they are perceived as slow-growing.

To find the stock’s historical P/E ratio, I select the “Normal Multiple” tab at the top of the Forecasting Calculator.

The graph changes so that the reference line (now drawn in blue) uses the stock’s own historical P/E ratio rather than the stock market’s historical average of 15 used in Step 1.

The pull-down menu at the lower left normally displays the 5-year “normal” P/E ratio of the stock. I usually use that 5-year average, although with the menu, you can pull it down and choose other lengths of time if you like.

I’ve circled the long-term P/E multiple in blue. It turns out that Starbucks is one of those companies that the market has been valuing highly: Its 5-year average valuation has been 30.0 rather than the 15 used in the first step.

Using 30.0 to draw the fair-value reference line changes the picture enormously. Now the stock looks undervalued.

By how much? We compute the valuation ratio exactly the same way as before:

Valuation ratio = Current P/E / Blue-line P/E

Valuation ratio = 22.0 / 30.0 = 0.73

Fair price is also calculated the same way as before:

Fair price = Actual price / Valuation ratio

Fair price = $52 / 0.73 = $71

So in this step, Starbucks calculates out to be extremely undervalued. Its actual price is 27% under its fair-value price.

The two steps so far have painted completely different pictures of Starbucks’ valuation. Let’s move along and see if we can get to a more consensus point of view.

Step 3: Morningstar Star Rating

Morningstar approaches valuation differently. They use a discounted cash flow (DCF) model for valuation. Many investors consider DCF to be the best method of assessing stock valuations.

Warren Buffet has said, “Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”

The DCF model ignores P/E ratios. Instead, it requires the analyst to model all of the company’s future profits (year by year out to infinity), then discount the sum of them back to the present to reflect the time value of money. That gets you to Buffett’s description of fair value. (If you want to learn more about DCF, I recommend this readable explanation at Moneychimp.)

Morningstar presents the results of their calculations in summary form. First they give the stock a star rating. They use a 5-star system where 1 star = extremely overvalued and 5 stars = extremely undervalued.

As of this writing, Morningstar calculates that Starbucks is undervalued (4 stars).

They also present their fair price:

Morningstar calculates a fair price of $64. That means that they think that the stock is selling at a 19% discount to fair value.

Step 4: Current Yield vs. Historical Yield

My last step is to compare the stock’s current yield to its historical 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 yield is higher than usual), the more desirable the stock is at today’s price.

If the yield falls toward the bottom of the historical range (yield lower than usual), it is likely that the stock is overvalued. History suggests that you will be able to get it at a better yield if you wait for the market to bring the price back to a more normal valuation for that stock.

Historical yields are available from a variety of sources. One easy way to visualize this valuation approach is to use Simply Safe Dividend’s historical yield display.

In this case, Starbuck’s yield (2.8%) is much higher than usual (5-year average is 1.5%), suggesting undervalutaion of the stock.

Again, we use a ratio to compute the degree of undervaluation.

Valuation ratio = 5-Year average yield / Current yield

Valuation ratio = 1.5% / 2.8% = 0.54

When using this method, I cut off the valuation ratio at 0.8 (using nothing below that), because this is an indirect valuation method, and it can be swayed by things like recent large dividend increases. So in this case, I would use a valuation ratio of 0.8.

Fair price is computed as in the first two steps.

Fair price = Actual price / Valuation ratio

Fair price = $52 / 0.8 = $65

Averaging the Four Estimates

To finish up, I simply average the 4 valuation methods.

Thus, I would conclude that Starbuck’s current price is 12% below its fair price. That means it is undervalued, and if you like other things about the company, now would be a good time to buy it. It’s selling at a bargain price.

It is unusual to see such a wide variation in fair price estimates as we see in Starbucks’ case, but it is not unusual to get different assessments from different methods. To quote Buffett again: “As our definition suggests, intrinsic value is an estimate rather than a precise figure.”

Some investors might steer away from Starbucks because of the wide disparity in valuation estimates. They might figure that Starbucks simply cannot be valued with any degree of confidence. (That would not be my conclusion.)

What About Other Valuation Methods?

I selected the four methods that I use based on my experience over the years. I have developed confidence in them, and I also want to combine different approaches to arrive at a conclusion.

That said, you may develop other sources and methods. For example, most brokerages give free access to  a variety of independent stock analyses. “Independence” is important in my book, because I wouldn’t trust valuation estimates from someone who is being paid to push a particular stock or point of view.

Such trusted sources might include CFRA (formerly S&P Capital IQ); Thomson Reuters; and Credit Suisse.

Key Takeaways from this Lesson

  1. Valuation is a way to determine whether a stock’s current price is fair, a bargain, or too high.
  2. Valuation is different from price. If all you know is a stock’s price, you don’t know whether that is a good or bad price.
  3. Valuation is also different from company quality. A high-quality company can be undervalued, and a low-quality company can be overvalued.
  4. 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.
  5. If you can buy 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.
  6. Using tools and sources available on the Internet, you can derive valuations from several methods in just a few minutes.

— Dave Van Knapp

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