Stock Valuation

- By Ankur Sharda, Author of ‘A Guide For Discerning Investor’ available on http://www.lulu.com/content/2816269

STOCK VALUATION: Earning Growth Average growth approximation: Assuming that two stocks have the same earnings growth, the one with a lower P/E is a better value. The P/E method is perhaps the most commonly used valuation method in the stock brokerage industry. By using comparison firms, a target price/earnings (or P/E) ratio is selected for the company and then the future earnings of the company are estimated. The valuation's fair price is simply estimated earnings times target P/E. Constant growth approximation: It assumes that dividends will increase at a constant growth rate (less than the discount rate) forever. Limited high-growth period approximation: When a stock has a significantly higher growth rate than its peers, it is sometimes assumed that the earnings growth rate will be sustained for a short time (say, 5 years) and then the growth rate will revert to the mean. This is probably the most rigorous approximation that is practical. Market criteria (potential price) Some feel that if the stock is listed in a well organized stock market, with a large volume of transactions, the listed price will be close to the estimated fair value. This is called the efficient market hypothesis. On the other hand, studies made in the field of behavioural economic or finance tend to show that deviations from the fair price are rather common and sometimes quite large. Thus, in addition to fundamental economic criteria, market criteria also have to be taken into account market-based valuation. Valuing a stock is not only to estimate its fair value, but also to determine its potential price range, taking into account market behaviour aspects. Once again to say that all theories are hypothetical and there are conditions applied to it. What can happen in unforeseen future nobody can tell and any estimates done for the future can be revised at any given point. One factor strongly affecting a stock’s price is earnings growth. All other things being equal, if a stock’s earnings grow by 20% in a given year, we might expect the stock’s price to also rise by 20% in order to maintain about the same P/E ratio. So before buying a stock, we would like to get an idea of how earnings may grow in the next year, two years or more. One way would be to look up the analysts’ predictions on future earnings-per-share (EPS) in either free or fee publications. Upto the period of 2 to 3 years one can still foresee the reasonable rise in EPS. One should always take into consideration on expansion of company during boom, stable or bust time of a particular industry cycle. Backward integration is one way where company can reduce cost of inputs and boost profitability whereas in the case of Forward integration, company can boost profit by selling finished goods to consumer. There is also one more important factor to consider is extra ordinary item (income or loss) in the balance sheet. It should be excluded while concluding the profits of a company. Investor should be able to estimate the time of completion of expansion,


restructuring, integration and various such factors which can affect the earnings of a company in future. These are micro factors where one can do analysis in forecasting EPS for the company. Stocks involved in commodity are comparatively easier to predict then consumer behavioural goods (like hotels, transportation, amusements, home appliances, automobiles etc.) because when the sentiment of consumer can change, nobody would know, and it falls under behavioural economics. However, we all have read stories of analysts having historically been overly optimistic, having poor track records and being pressured by their employers to give high growth estimates for certain companies. What if the EPS is manipulated by the companies themselves? During boom times, all companies prefer good results so that their stock price will go up and they can raise money at minimum cost. After the meltdown of asset bubbles, several large companies found guilty of manipulating EPS, reports and such other micro factors. Soon after the meltdown of NASDAQ, one of the top 5 accountancy firms was involved with the management in manipulating the balance sheets. There are still so many hidden facts which never came out. When the bear market persists that is the time one can judge the real strength of financial health of the company. But if one has excelled, you can enter some simple formulas and become your own stock analyst. We are trying to predict the future just like the analysts, which is not easy. Future projection of an asset price backed by valuation is nothing but speculation where one is trying to predict the future based on knowledge. But at least we know predictions will only be based by one thing - the actual historical earnings of the company. With the proven track record of growth of average 20% per annum on averaging last 5 years earnings could help you determining the growth for next 5 years. Any analysts’ job is to predict future earnings where some times targets exceed their prediction or some times targets go completely wrong. Well, when the target exceeds, nobody shall say a word where he or she has failed in prediction because target has exceeded more than expectation, but in an otherwise case, he or she shall be condemned. Share prices in a publicly traded company are determined by market supply and demand, and thus depend upon the expectations of buyers and sellers. Among these are: 1. The company's future and recent performance, including potential growth. 2. Perceived risk, including risk due to high leverage. 3. Prospects for companies of a particular industry, the market sector. By dividing the price of one share in a company by the profits earned by the company per share, you arrive at the P/E ratio. If earnings move up in line with share prices (or vice versa) the ratio stays the same. But if stock prices gain in value and earnings remain the same or go down, the P/E rises. The price used to calculate a P/E ratio is usually the most recent price. The earnings figure used is the most recently available, although this figure may be out of date and may not necessarily reflect the current position of the company. This is often referred to as a 'trailing P/E', because it involves taking earnings from the


last four quarters. The P/E ratio implicitly incorporates the perceived riskiness of a given company's future earnings. Variations on the standard trailing and forward P/E ratios are common. Generally, alternative P/E measures substitute different measures of earnings, such as rolling averages over longer periods of time (to "smooth" volatile earnings, for example), or "corrected" earnings figures that exclude certain extraordinary items or one-off gains or losses. The definitions may not be standardized. Various interpretations of a particular P/E ratio are possible and the historical table as follows is just indicative and cannot be a guide, as current P/E ratios should be compared to current scenario:

N/A A company with no earnings has an undefined P/E ratio. As a normal practice, companies with losses are usually treated as having an undefined P/E ratio. Still a negative P/E ratio can be mathematically determined.

0–10 Either the stock is undervalued or the company's earnings are expected to be in decline. Alternatively, current earnings may be substantially above historic trends or the company may have profited from extraordinary items.

10–20 For many companies a P/E ratio in this range may be considered fair value.

20–30 Either the stock is overvalued or the company's earnings have increased since the last earnings figure was published. The stock may also be a growth story stock with earnings expected to increase substantially in future.

30+ A company whose shares have a very high P/E may have high expected future growth in earnings or the stock may be the subject of a speculative bubble.

It is usually not enough to look at the P/E ratio of one company and determine its status. Usually, an analyst will look at a company's P/E ratio compared to the industry the company is in, the sector the company is in, as well as the overall market. Only after a comparison with the industry, sector and market can an analyst determine whether a P/E ratio is high or low with the previously stated distinctive table (i.e., undervaluation, over valuation, fair valuation, etc).


High P/E ratios in context to USA: June 1901=25.2 (Twentieth Century Peak) Sept 1929=32.6 Jan 1966=24.1 (Kennedy-Johnson Peak) Jan 2000=44.3 (Dot com Peak) What are the “strong hands” and the “weak hands”? Strong hands are large funds or wealthy investor invests huge funds generally at bad times or down markets. They know and understand the market because they hold the large chunk of floating stock. It is the question of owning and disowning the assets. One should always remember where the strong hands are moving. They are also called “Smart Money”. They are the long term trend setters for any asset class. Larger the share of weak hands more risky for markets. When the strong hands move in, it will be a bear market, at the same time weak hands are out of it (Example: Warren Buffet bought tons of Silver during 9/11 terror attack when the entire world was falling across all the asset classes). What are the weak hands? It is simple, just the opposite of the strong hands. They generally comprise of active traders, new funds, common man, professional and intellects from finance world those who are scattered for short tem gains. It is the strong hands those who decide to give PE ratio to a particular sector/ industry/ markets of the world. It is the willingness of investor to buy shares at higher level hence PE ratio is set for a particular industry. That is why there are always buyers and sellers at every level. There is never a bench mark for PE ratios. There is always fundamental reasoning behind it where one can keep on buying shares looking at the future and being confident about it. Many times it is proven with track records and the management ability to grow in future. It is true. If an investor is ready to buy large number of shares at higher price then he or she justifies the higher PE ratio. To simplify it, strong hands when they corner large chunk of floating stock then they ask the remaining stock at higher levels justifying it with growth story and other reasoning. What is logic and illogic? Sometimes there could be no logic and illogic in assets, stock markets and commodity markets. Fundamental could be related to logic. People generally get trapped for their emotions (fear and greed) and also the intellects having excess knowledge where they fail to understand human emotions and biases. A psychologist could be a better fund manager than a financial wizard. Nobody could understand markets at any point given but there are lot of things to say. It is believed that high crude price is not good for equities. Crude rallied from US$ 18 to 145 from 2002 to mid 2008 and at the same time equities in emerging markets gave extremely high returns while western equity markets gave reasonably handsome returns. It is just the sentiments. Logic is defied. Still, I believe it is 65% logical where fundamentals have a say and 35% psychological in context to stock markets. Logic is still the fundamental driver for change in psychology of the markets. Stock valuations can go high or low from time to time and to any extent due to psychological factors. Stock valuations are fundamental way of analysis where financials


are taken into consideration for buy and sell decision making by looking into it whether it is cheap or expensive. So, it does not mean by knowing fundamental analysis one can out perform the stock market. Sometimes stock can be under valued at higher level of stock market or may be over valued at lower level of stock market. Index level and stock valuations together should not be compared for decision making of buy and sell. Psychological factors can influence more than fundamental factors for the stock valuations due to temporary disorders. Irrational decisions, may be selling at bottom or buying at top of price levels can change valuations from time to time and to any extent where right decision to enter or exit can be taken with the help of proper fundamental analysis of individual stocks. There is clear evidence from the past that in every asset price inflation there is always a deep price correction. But when there is exorbitant price inflation then it leads to attraction of everyone to gain maximum in short period. It further inflates the price without realizing the real fundamental values. After a prolong sustain high prices in any asset class, at a certain point, may be due to any reasons like intervention of government, natural calamity or negative news, prices start to correct. Eventually, there is realization that the asset prices were extremely inflated and selling spree begins without any question. Tulip mania got burst with as a result of being infected with a tulip-specific virus known as the "Tulip Breaking pot virus" and high price in short period of time. This was the reason of crash and before the bubble burst, there was the euphoria to hoard flowers by the merchants. South Sea bubble burst was the result of irrational exuberance where there was mad rush to buy shares of the company. It started with the cracking deal with the government of monopolistic trade of slaves. Business grew like anything and so were the investors in the company. Huge price movement upwards is not sustainable by any means and people realized that prices were not justifying the real worth of the company. Florida land boom is also the best example of real estate bubble which got broke out due to delay in rail road, natural calamity and general downturn in the economy. These were the reasons of bubble burst, but in reality it was the asset price inflation which had to burst finding its justification. Density of population was too low to justify the high real estate prices. Wall Street collapse, Nikkei crash, Asian crisis and NASDAQ crash are the perfect examples of stock market crash where P/E ratios were very high that means challenging the fundamentals. In 2000, P/E of DJIA was 44 and NASDAQ above 100, historical in the entire 20th century. Eventually it leads to crash and so it did. Looking back at over 100 years of data for the Dow Jones Industrial Average (DJIA), it is clear that stocks become over valued, i.e. too expensive, when their P/E ratios exceed 21. These lofty P/E ratios represent major tops and prices fall from there until P/E ratios return to the long-term average of 14, and then continue beyond that to a level where they are under valued, i.e. P/E ratio of around 7. The data proves that the 1901 top was formed at a P/E ratio of


25, which resulted in a 20-year bear market that finally bottomed in 1921 at a P/E ratio of 5. The 1929 top was formed at a P/E ratio of 32.6, which resulted in a 3-year bear market that bottomed in 1932 at a P/E ratio of 5. The 1966 top was formed at a P/E ratio of 24.1, which resulted in a 16-year bear market that bottomed in 1982 at a P/E ratio of 6.6. History has shown that after a major top, a multi-year bear market should take prices back to a P/E ratio of 5-7 again, in order to work off the excesses of the previous bull market. Nikkei crossed the P/E multiples of more than 90 when it touched near about 40000 levels and soon succumb to the law of gravity. Real estate and stocks both were marching upwards. Soon it crashed to P/E multiples of 33 then coming down to 20 P/E. Such indicators could be used to take sell or buy decisions in stock market. Similarly like Japan, was the case of Asian Tigers where real estate and stock market was going only in one direction which was up. P/E ratios varied from 25 to 40 from country to country in South East Asia with lowest was Singapore and highest was Thailand and Korea. Soon after realizing the crash, reasoning came up. Actually it was the wealth effect which worked negatively due to fast deflation in asset prices. Sub-prime crisis was the result of crash of DJIA and NASDAQ when there was down turn in US economy. Fed decreased interest rates to such low level that it was attractive to borrow and invest in property market. To revive the falling economy, Fed increased the money supply so that housing market will prop up the slow economy. The housing market was picking up and the same time money supply increasing with the lowest interest rates, it grabbed the attention of investors and speculators along with the weak borrowers. Real estate prices were rising and parallel to it was the increase in interest rates and squeezing of the money supply by Fed, which burst the bubble of housing market as well as financial markets. Real estate prices were not justified as prices were going up without the support of rentals. High P/E ratio in housing market was the clear evidence of bubble burst. When there is madness of the crowd, there is no reasoning and at the same time sophisticated and rational investors allow the asset prices to go up so that they can take the advantage of high prices. During this irrational phase, knowledge and new theories are sold to general investors where they always go right by doing it so. Sophisticated and rational investors allow the asset price to inflate or deflate and do not interfere by selling or buying, so that they can the advantage of irrational behaviour of markets. General investors clinch every deal right for themselves which further boost the confidence and blinds the rational mind. This is how bubbles develop and burst due to any factor which can stop the upward journey. Markets are efficient but due short term distortions like the psychology of investors play an important role to create irrational behaviour in markets. That is why behavioural finance has an important role in determining the medium term (1-2 years) of asset price movements. Eventually on long term basis, markets are efficient and Efficient Market Hypothesis works where asset prices move like river to attain equilibrium. Markets behave irrationally in both times of the bull and the bear markets. Markets can fall from very high P/E ratio to unrealistic P/E ratio of 5 to 7 and that can


happen due to correction of major bull market to bear market. Average P/E ratio should remain between 10 to 14 levels. Nobody has the formula, method or any kind of theory to calculate the end of high level of bull markets and the P/E ratio of stock markets. It is the sheer judgment of a human capability to contend with the valuations and to take a call to buy or sell. It is true that nobody can buy at bottom and sell at top. Market is always right. In the recent scenario, till mid 2008, where there were flow of several bad news like global subprime crisis and rising inflation, interest rates and commodity prices, investors’ confidence would fall despite the markets emerge from their lows. It is understandable that the big decline in the markets and spiralling commodity prices, especially crude oil, loom large over the psychology of the investors. Aggravating these concerns are the repercussions of the burgeoning fiscal deficit on account of subsidies borne by the governments. The economists have always raised their eyebrows on these issues, but investors are trying to interpret these issues having what kind of impact on the markets. So, what investors should do? Once again, one should not bother too much about these factors and should concentrate on where the smart money or the strong hands are moving. Any consistent yearly rise in asset prices shall end with the madness of crowd. Commodity price rise and inflation made their peak upto August 2008 and thereafter bubble in crude oil got burst which later on spread to other commodities also. Aluminium, copper, zinc, steel, crude oil, wheat, rice etc. are the commodities which fell like pack of cards. Prices corrected as much as 65% in major basic metals. Gold is still showing strength by price correcting approximately 30% from its peak. It holds good potential for future price appreciation. Substantial fall in commodity prices lead to deflation and simultaneously recession in developed countries. Fortunately, it is boon for emerging countries where they were struggling with inflation. The entire turmoil in global markets will take sometime the dust to settle. Hence, I would note it as an opportunity to increase investments in emerging countries of their respective stock markets, real estate and gold rather than bothering the external factors. Rest of the emerging stock markets like BSE Sensex of India got slightly expensive in terms of P/E ratio where it was 22 and immediately correction of approximately 60% from its peak of 21000 took place which is healthy from long term point of view. Demography of India protects itself from global turmoil as the majority of sectors in the economy are dependent on the country’s growth rather than the global growth. This will be the reason for global investors to invest in India and BSE Sensex shall command a high P/E ratio to other countries in the world. There will be big sectoral story play out with huge investments in infrastructure like construction, power generation, power equipment and consumer goods. No doubt there is an impact on the growth of economy due to crash of commodities which is the result of sub prime credit crisis in USA. Investments in metal and related industries would slow down and it will have negative impact on the Indian economy for a while. Consumer spending shall increase with fall in consumer goods prices as buying power will go up with deflating commodity prices. Huge pipeline investments in infrastructure like power and construction shall lead to growth in India which shall spread to consumer spending also, as wealth effect will take


place. Eventually, stock market will rise with any bullish trigger when BSE Sensex shall also enter into high P/E ratio trajectory and growth story of India shall be sold worldwide, gradually it will lead to irrational behaviour. As of now, India was relatively cheap to invest at sub 8000 levels where investment should be made with 3 to 5 years time frame. Growing economy with 8 forward P/E multiples is definitely worth to invest in India where the market had already corrected 60% from its peak. By any standards, PE ratio of 8 is cheap and it shall reward investors handsomely if invested in the times of global turmoil. There is no doubt that there is strong relation between economy and stock market where economy is the fact and stock market is the psychological barometer of economy. Should economic parameters be the sole criteria for investing in equities? Firm Foundation theory should be used where valuations and growth play an important role in judgement of investments in equities.

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Stock Valuation