The Five Rules for Successful Stock Investing 10

Valuation – The Basics

Even the most wonderful business is a poor investment if purchased for too high a price. To invest successfully means you need to buy great companies at attractive prices.

Investors purchase an asset for less than their estimate of its value and receive a return more or less in line with the financial performance of that asset. Speculators, by contrast, purchase an asset not because they believe it's actually worth more, but because they think another investor will pay more for it at some point. The return that investors receive on assets depends largely on the accuracy of their analysis, whereas a speculator's return depends on the gullibility of others.

Over time, the stock market's returns come from two key components: investment return and speculative return. [...] the investment return is the appreciation of a stock because of its dividend yield and subsequent earnings growth, whereas the speculative return comes from the impact of changes in the price-to-earnings (P/E) ratio. [...] over a long time span, the impact of investment returns trump the impact of speculative returns.

By paying close attention to the price you pay for a stock, you minimize your speculative risk, which helps maximize your total return.

The most basic ratio of all is the P/S ratio, which is the current price of the stock divided by sales per share. The nice thing about the P/S ratio is that sales are typically cleaner than reported earnings because companies that use accounting tricks usually seek to boost earnings.

The P/S ratio has one big flaw: Sales may be worth a little or a lot, depending on a company's profitability.

Although the P/S ratio might be useful if you're looking at a firm with highly variable earnings – because you can compare today's P/S with a historical P/S ratio – it's not something you want to rely on very much. In particular, don't compare companies in different industries on a price-to-sales basis, unless the two industries have very similar levels of profitability.

Another common valuation measure is price-to-book (P/B), which compares a stock's market value with the book value (also known as shareholder's equity or net worth) on the company's most recent balance sheet. The idea here is that future earnings or cash flows are ephemeral, and all we can really count on is the net value of a firm's tangible assets in the here-and-now.

When the market was dominated by capital-intensive firms that owned factories, land, rail track, and inventory – all of which had some objective tangible worth – it made sense to value firms based on their accounting book value. After all, not only would those hard assets have value in a liquidation, but also they were the source of many firms' cash flow. But now, many companies are creating wealth through intangible assets such as processes, brand names, and databases, most of which are not directly included in book value.

Another item to be wary of when using P/B to value stocks is goodwill, which can inflate book value to the point that even the most expensive firm looks like a value. When one company buys another, the difference between the target firm's tangible book value and the purchase price is called goodwill, and it's supposed to represent the value of all the intangible assets – smart employees, strong customer relationships, efficient internal processes – that made the target firm worth buying. Unfortunately, goodwill often represents little else but the desperation of the acquiring firm to buy the target before someone else did, because acquiring firms often overpay for target companies. Be highly skeptical of firms for which goodwill makes up a sizable portion of their book value.

A company that's trading at a lower P/E than its industry peers could be a good value, but remember that even firms in the same industry can have very different capital structures, risk levels, and growth rates, all of which affect the P/E ratio. All else equal, it makes sense to pay a higher P/E for a firm that's growing faster, has less debt, and has lower capital reinvestment needs.

In general, comparing a company's P/E with industry peers or with the market has some value, but these aren't approaches that you should rely on to make a final buy or sell decision. However, comparing a stock's current P/E with its historical P/E ratios can be useful, especially for stable firms that haven't undergone major shifts in their business. If you see a solid company that's growing at roughly the same rate with roughly the same business prospects as in the past, but it's trading at a lower P/E than its long-term average, you should start getting interested.

Because risk, growth, and capital needs are all fundamental determinants of a stock's P/E ratio, higher growth firms should have higher P/E ratios, higher risk firms should have lower P/E ratios, and firms with higher capital needs should have lower P/E ratios.

When you're looking at a P/E ratio, you must be sure that the E makes sense. If a firm has recently sold off a business or perhaps a stake in another firm, it's going to have an artificially inflated E, and thus a lower P/E. Because you don't want to value the firm based on one-time gains such as this, you need to strip out the proceeds from the sale before calculating the P/E.

Don't rely on any single valuation metric because no individual ratio tells the whole story. Apply a number of different valuation tools when you're assessing a stock.

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