In almost every article I have ever published, I talk about valuation in one manner or another. So much so, that readers have dubbed me Mr. Valuation. The primary reason I am so obsessed about valuation is because I believe it is one of the most important and yet mostly ignored and overlooked concepts in the investing world.

I have been in the investment industry since 1970, and my experience clearly supports this previous statement. Investors focused on stock price movement will throw any consideration of valuation out the window.

When a stock is rising it’s a good stock, and if the stock price is falling it’s a bad stock regardless of the underlying fundamental strengths or the valuation of the holding.

What makes valuation so hard for many investors to consider can be easily understood by examining one of the greatest lessons on valuation ever offered.

The venerable Ben Graham offered the now famous metaphor as follows: “in the short run the market is a voting machine, but in the long run it is a weighing machine.” What his metaphor is telling us is that the market is emotionally driven in the short run and therefore may not always be reflective of fundamental values. People vote their dollars (purchase or sell stocks) in the short run primarily based on recent price activity. As a result, a stock can have either positive or negative momentum over short periods of time, again, regardless of fundamentals.

The undeniable truth is that human beings are emotional creatures. And as it relates to investing, the primary emotions that investors must deal with are fear and/or greed. When either of these emotions take hold, logic and sound reasoning tends to go out the window. But the most insidious aspect of this short run “voting machine” behavior is that it is totally unpredictable because it is all too often irrational.

In my opinion, it is this last point that makes it so difficult for many investors to embrace the important principles of sound valuation. Once a stock enters extended levels of overvaluation, any number of things can happen over the short run, and all of them are unpredictable.

On the other hand, one thing that is predictable is that long-term returns will be greatly diminished by overvaluation. This is an inevitability, however, the precise timing cannot be forecast or calculated. In other words, an overvalued stock can immediately go into a quick freefall or it can go sideways for months or years to come. Additionally, when a stock has short-term “voting machine” momentum, it can continue to rise as it becomes more and more overvalued with each passing day. Unfortunately, there is no way to quantify irrational behavior.

In contrast, in the long run the statement that the market is a weighing machine suggests that true worth fundamental value will inevitably manifest.

What makes stocks valuable in the long run is how well the business performs as an operating entity. Moreover, the rate of change of earnings and/or cash flow growth will also be a primary determinant of how much and how fast the company increases its true worth value. However, as far as investor returns are concerned, those returns will also be directly affected by the stock’s valuation levels. If the stock is overvalued, then future returns will be less than the company’s operating achievement – and vice versa.

However, what is also misunderstood about this is that it is a mathematical principle rather than an opinion. For example, in my most recent article where I pointed out the high valuation of Microsoft (MSFT), several readers commented that they disagreed with me. I find that confusing, because as I stated in the written portion of that article the numbers don’t lie. The company’s earnings and/or cash flows and other fundamental metrics to include the dividends, are what generates results in the long run. Furthermore, this can be determined by simple mathematical principles. Therefore, I often state that measuring performance without simultaneously measuring valuation is a job half done. As a corollary to this last statement, I also often state that investors need to apply the discipline of running the numbers out to their logical conclusions.

There Are Many Ways to Calculate the Fair Value of a Business

Perhaps the most important thing that can be stated about calculating the fair valuation of a stock is that it cannot be done with perfect precision. The underlying businesses behind the stock are dynamic living entities. As such, their businesses are constantly evolving. This is also important when you are utilizing fundamental metrics, for example, P/E ratios. The P/E ratio is a calculation that is typically based on the company’s most recent earnings report. However, those earnings typically were generated months ago. Therefore, the company’s current level of earnings will be modestly different than the actual earnings that the P/E ratio is calculated upon.

Consequently, although you cannot calculate fair value with perfect precision, you can calculate it within a reasonable range of error. Although your calculation will not be perfect, it should be relevant enough to base sound investing decisions upon. What I mean is, if you calculated the value of a business at $10 billion and discover that the market is valuing it at $15 billion, you should immediately recognize the market value disconnect from true worth value. In other words, you should immediately realize the company is overvalued by approximately 50%.

Moreover, as the title of this section indicates, there are many methods and ways to ascertain the fair value of a company. For example, there are numerous ratios such as the P/E ratio, price to cash flow, price to EBITDA, price to sales, price-to-book value, etc. Personally, I prefer to utilize them all – or at least as many as I can readily determine. Again, I’m not trying to be perfect, instead, I’m trying to be essentially correct in determining what a business is worth. I am not concerned with minor deviations above or below my calculations. Instead, I am looking for material variances that simply do not make economic sense. To me these represent obvious mistakes that investors could, and should, avoid if they are disciplined enough to run the numbers to their logical conclusions.

In addition to the above ratios, you could also ascertain the fair value by comparing historical dividend yields, and of course, the all-important earnings yield – which is the inverse of the P/E ratio. Earnings yield can also be carried over into cash flow yield, EBITDA yield, etc. Moreover, the rate of change of growth relative to these calculations is also vitally important.

Simply stated, you can pay a higher valuation for a faster grower than you can a slow grower and still do well in the long run. Nevertheless, the point is, at some level the numbers must add up. Otherwise you are simply speculating rather than investing. The former implies short-term activities, while the latter implies taking a long view.

25 Real-Life Examples Illustrating the Many Nuances of the Dangers of Overvaluation

In the following video, I’m going to present 25 real-life examples of how high valuations affect long-term shareholder returns. Because I will be covering so many companies, I’m going to keep each example short and sweet. My objective is to illustrate how overvaluation can manifest into poor future returns under many different scenarios and circumstances. Nevertheless, the primary point is that overvaluation always leads to long-term disappointments. The numbers simply do not lie.

Summary and Conclusions

My simple advice is to learn to recognize overvaluation when it manifests. Furthermore, once you recognize overvaluation go ahead and run as many “what if” calculations as you can. Apply the discipline to go through this process because it will clarify your thoughts relative to the investment merit of any stock you have invested in. Turn your opinions into mathematical factual assumptions and you will perform better over the longer term. This is in my experience, and I’m simply sharing it so that you may have similar experiences.

— Chuck Carnevale

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