Staying Rational in a Falling Market, using rational price or rational value approach

Read the Market's Long-Term Performance

By Ellis Traub | September 16, 2008

Those "buy-and-watch" physician-investors have experienced one of the most unsettling periods in their investment lives. They've seen the value of investments soar to heights that would have cast a shadow on Icarus, and then plummet to depths that few of us have ever seen. These extraordinary bubbles and busts have tested the faith that many have in fundamental investment principles and likely caused some to abandon their discipline. Many who stayed the course are still questioning whether they should have been able to tell when the market was going to take its dive.

KEEP PERSPECTIVE

Of course, the best way to keep your mind at ease through times like these is perspective. Those who are thoroughly grounded in long-term thinking know that these kinds of events are transient and will eventually work out. Patience and vigilance are the only attributes an investor needs to get through them. A new approach is found in rational price or rational value, which pertains to a portfolio whose stocks have been priced at their rational prices.

There's no question that the most recent bubble was the product of what Federal Reserve Chairman Alan Greenspan termed "irrational exuberance."We now know that in the course of a year, the price of a stock can go up or down, departing as much as 50% from the average price. The distortion that applies to the price is also applicable to the price/earnings (P/E) ratio, which is a function of the price. Viewing the P/E ratio as merely a rate you pay for a dollar's worth of earnings makes perfect sense.

During the course of a 5-year cycle, the market's P/E ratio will typically make even greater departures from the norm. And several times during a century, excursions from the average can be extreme and either delightful or painful.

The significant thing for physician-investors to remember is this: If the price is truly driven by earnings in the long term, and successful methodology says that it is, then deviations in the P/E ratio, the "rate," must be caused by something other than earnings. If it weren't, the price and P/E ratio would always march in absolute lock step with the most recently reported earnings per share.

KNOW THE HUMAN FACTOR

What is that mysterious force that causes the price and P/E ratio to vary up and down, sometimes by huge amounts? It's nothing more than the collective perception or opinion about the effect that the daily host of media reports, stories, current events, earnings forecasts, speculation, etc, will have on the economy, the market, an industry, or a company. It's fear, greed, paranoia, and euphoria that uninformed or over-informed speculators act on. These change every minute; reported earnings do not.

How, then, should you compensate for these fleeting, disconcerting, and often misleading trends? We recognize that the daily, short-term fluctuations in the P/E ratio are not important when compared to earnings over the long term. This allows us to calculate a rational price for each of our stocks and a rational value for our holdings.

Simply stated, the rational price tells what the price of our stock would be if the public's decisions to buy or sell were governed by earnings and not by all the unpredictable factors. In effect, the rational price answers the question, "If the public really had it together, what would they be paying for my stocks?"

To calculate a price, use the "signature P/E ratio" and earning per share. The simplest way to do this is to multiply a company's 10-year average P/E ratio by the most recent trailing 12 months' earnings. Once you've calculated your rational prices, you can analyze your portfolio and calculate its rational value (ie, the sum of the products of the number of shares and their rational prices).

The benefit to be derived from this exercise is significant. It puts whatever irrationality Mr. Market might be currently laboring under into perspective and gives you a view of just how irrational he is at any time. It's a way to quantify just how right you are compared to the rest of the world, which goes a long way toward providing comfort when times are bad, and tempering euphoria when they're good. And, if nothing else, it may be just the encouragement a physician-investor needs to stay the course. That may be the best medicine of all.

Ellis Traub, author of Take Stock: A Roadmap to Profiting from Your First Walk Down Wall Street (Dearborn; 2000), is chairman of the Inve$tWare Corp (www.investware.com), manufacturers of stock analysis software. He welcomes questions or comments at 954-723-9910, ext 222, or etraub@investware.com.

- See more at: http://www.hcplive.com/publications/pmd/2003/53/2654#sthash.4g85ciyZ.dpuf

Rational Value: Your Key to Contentment (Ellis Traub)

Rational Value: Your Key to Contentment

May 8th, 2009

Many of my posts have referred to rational value. And I’ve been remiss in not making a special effort to define this term for my readers—one I coined several years ago to try to help investors like us keep their minds on what’s important. The significance of this term is that it can keep our feet on the ground when the market is overvalued, and keep our head in the clouds when it’s in the tank. And, on an ongoing basis tell it will us what the reasonable (rational) value of our shares would be.

Rational Value Defined

Simply defined, Rational Value is the approximate value of a share of stock were it to be selling at its rational price—the price investors would pay for it if it were selling at its historical average multiple or “signature PE.”

If you have calculated either the Historical Value Ratio (HVR) or the Relative Value (RV), the simplest way to determine its Rational Price is to divide the current market price by either of those figures.

If, for example, the HVR or RV of XYZ company is 50%, and the current market price were $50, dividing the $50 by .50 would give you a rational value of $100—the price one would pay for it if one were “rational.” So, as you can see, the rational value is the value of your shares when the RV or HVR are 100%.

For those who have not been exposed to either RV or HVR, let me explain and define these terms for you.

Relative Value or Historical Value Ratio

Our methodology is based upon a very basic premise: “Real” investors—those who own stock as part owners of the businesses that have issued it—attach a value to their ownership that is related to the ability of those businesses to earn money and to grow. That relationship between a company’s earnings and the market price of the stock is recognized as the Price Earnings Ratio (PE). [For a more detailed discussion of this relationship and its importance, read "What's a PE and What's it To Me?"] For our purposes here, let’s define the PE simply as the unit price for one dollar’s worth of a company’s earnings.

You can tell if a gallon of gas is cheap or expensive because its price is under or over a “typical” or average price that’s fairly familiar to you. And an investor similarly knows if a share of stock is overpriced or inexpensive, based up what it has typically sold for. Because the price of the shares of a company will vary over time and the PE is relatively stable, we use the multiple of earnings it has sold for—its PE—rather than the price, itself, to judge its value. And that determination is what the HVR or RV provides us.

The RV is a comparison of the current PE with the historical (five-year) average and is calculated by dividing the current PE by that historical average PE. The HVR is similar, except it’s derived by dividing the current PE by the historical (ten-year) median. [The median is the middle value in a series of values and is not unduly influenced by wide swings or outliers.]

That mid-point, however you calculate it, becomes the stock’s “signature PE”—the multiple at which the stock would sell if it were purchased strictly for its earnings performance. By taking the longer term view, we effectively cancel out the short-term ups and downs of the price that are caused by the herd’s whims and guesses. These, of course, are measured—as if we care—by the amplitude of the distance betwen the high and low PEs either side of that mid-point.

It’s the amplitude of the swings either side of that signature PE or mid-point that measure the “rationality” of the price. If everyone were rational; i.e., if everyone were to buy or sell the stock based upon its underlying company’s earnings, the price would be “rational” all the time. However, in times like these, when “irrational despair” prompts the herd to panic and sell its shares, the price of those shares becomes irrationally low. Of course, in the opposite extreme, when the public is “irrationally exuberant,” as former Fed Chairman, Alan Greenspan labled the condition, the prices were irrationally high!

Therefore, the rational price of a share of stock is simply the price that would be paid for the stock if everyone were rational. And, the beauty of this concept is, because the “rational value” is derived from the midpoint of sales and purchases over time, it’s easy to be confident that we will see the price return to that point—and probably overshoot it—when those investors come back to their senses.

Application of Rational Value

The normal cycles in the stock market are caused, in large measure, by the herd’s overshooting in both directions. But, don’t knock it. That’s what makes for the bargains from time to time. It also provides us with an additional opportunity to improve our portfolios’ performances by replacing a position, when it’s so overvalued you can no longer expect a reasonable return on it over the next five years, with one of as good quality but which has a better potential for return.

To sum up, the “rational value,” therefore, is a value of a your holdings to which you can count on your shares returning when the herd comes back to its senses. And that’s the only value you need be concerned about as you perform your portfolio management tasks.

So, sit back, relax, and wait for that to happen. It may take a little longer than usual because the herd is more demoralized than usual; but the value is there, and it will continue to be. Someday soon, we’ll start to see the more intelligent of investors, satisfied that the market has shaken out the last few of its gamblers, backing up the truck and starting to cart off those bargains. And, not long after that, the herd will thunder back, wanting to get on the bandwagon.

http://www.financialiteracy.us/wordpress/articles/rational-value-your-key-to-contentment/

Take Stock with Ellis Traub

Food for thought

• Introduction to Successful Investing
• Investing: How Simple Can it Be? Part 1
• Investing: How Simple Can it Be? Part 2
• Investing: How Simple Can it Be? Part 3
• Making Money, Part 1: What does it really mean?
• Making Money, Part 2: It Started with Barter
• Making Money, Part 3: Why is Our Healthy Economy Vulnerable?
• OpEd article by Warren E. Buffett in the NYTimes October 16, 2008.
• Rational Value: Your Key to Contentment
• Six Really Simple Steps to Buying a Quality Company
• The Growth Cycle
• The Only Ten Terms You Need to Know
• What’s a P/E, and What’s it to Me? Part 1
• What’s a P/E and What’s it to Me? Part 3
• What’s a P/E, and What’s it to Me? Part 2
• What’s Wrong with the Stock Market?

There are only two things you need to learn about a company and its stock:
• Is the company a good company?
• If it is, can you buy it at a reasonable price?

There are only two things you need to know to determine if it’s a well-managed company.
• Is the growth of its revenues and its profits strong and stable?
• Can its current management sustain its successful track record?

Both of these issues can be determined by looking at graphs of readily available data that you can plot yourself.

The concept of Rational Value of a Portfolio (Ellis Traub)

Re: Toolkit 5 and rational Value
Financial Literacy for Youth
Thu, 30 Dec 2004 18:34:18 -0800 (PST)

Diane:

At 08:57 PM 12/30/2004, you wrote:

The Portfolio Report Card Overview section of Toolkit 5 has a new concept,
called rational value. I'm trying to understand how the the number is
calculated.

----

You should be able to arrive at it by dividing the current price of
each stock by its relative value and multiplying that result by the
number of shares.

The concept behind this value is that each company has a fairly
constant PE (we like to call it the "signature PE") at which it has
sold. This is its historical average and represents a price (expressed
as a multiple of earnings) that has proven to be reasonable. The PE
is a rate investors are willing to pay for a dollar's worth of earnings
(much like the price or rate for a pound of coffee or gallon of gas).

When the PE is above that signature PE, it's selling at a higher rate
than "normal" and, conversely, when it sells below that value, it's
selling at a lower than "normal" rate.

The "Rational Price" (current price divided by the Relative Value)
is the price at which the stock would be selling were it to have
a Relative Value of 100%. In other words, it's the "normal" price
for the stock based on history. The "Rational Value" is the value
of your holdings if people were to be paying that "rational" price
for the stock.

The value is in setting a realistic value on your portfolio so that
you can see if, in the present market, your portfolio and its
holdings are above or below what it "should" be if people were
paying that rational price. It's supposed to keep you feet on the
ground in a bubble and your head in the clouds in a bust.

Ellis Traub





Terminology:


Signature PE =  The fairly constant PE at which the stock has sold.


Relative (PE) Value = Current PE / Signature PE


Rational Price of Stock 
= Price at which the Stock would be selling were it to have a Relative Value of 100%
= Current Price of Stock / Relative Value


Rational Value of a Stock in a Portfolio 
= Rational Price of Stock X Number of Shares
= [(Current Price of Stock / Relative Value) X Number of Shares]


Rational Value of a Portfolio 
= Sum of the Rational Values of Each Stock in the Portfolio
= Rational Value of Stock A + Rational Value of Stock B + Rational Value of Stock C + ......


http://www.mail-archive.com/i-club-list@lists.better-investing.org/msg04788.html


Relative Values and Rational Prices of Selected Stocks in KLSE.

https://spreadsheets.google.com/pub?key=0AuRRzs61sKqRdEdTREYtNTVQYnZtS1hfMDlSQjc3elE&output=html