PEG and Payback Periods

If you own a home or a car, you are probably all too familiar with what happens when you take out a loan.

• A bank lends you a certain amount of money that you must pay back at a specified rate, such as one payment per month for five to 30 years. 
• In exchange for taking a risk that you won't repay the loan, the bank earns some revenue on top of its investment, based on the interest rate it charges.

 As a shareholder in a company, you're a lot like a bank. 

• When you buy stock, you're in essence lending a company your money so it can buy what it needs for its business and (hopefully) grow. 
• You get paid back as the company's earnings grow and its stock appreciates. 

But whereas a bank clearly establishes its profit margin and a timetable for being repaid, shareholders aren't that lucky. (It's a different story for bondholders, who literally loan the company money and do get scheduled interest payments.) 

It is possible, however, to estimate what you may earn on your investment and when you'll earn it by examining a stock's payback period. 

Valuing Stocks - Absolute or Intrinsic Valuation

The two basic method of valuing stocks are;

• Relative valuation
• Absolute or Intrinsic valuation

Usually, absolute value is estimated by calculating the present value of the company's future free cash flows (cash flow minus capital spending).

The present value of that future-income stream is the theoretically correct value of the stock.

This method has its own difficulties and is less frequently used, but absolute value deserves a place in every investor's arsenal of valuation tools.

Calculating the absolute value of a stock isn't easy.  It is tough to forecast:

• how fast a company's free cash flow will grow, 
• how long they'll grow, and 
• at what rate they should be discounted back to the present.  

We estimate stocks's absolute values by inputting our estimates of a company's growth rate, profitability, and the efficiency with which it uses its assets into a discounted cash flow model.  The result is an analyst-driven estimate of a stock's fair value in absolute terms.

In an imperfect world, opting for the much easier - if less pure - method of relative valuation often makes sense.  

However, when the companies you are using as your benchmark are themselves mis-priced, relative valuation can lead you astray; without a reliable measurement tool, your measurements will be off.  That last point is crucial.

If the S&P 500, for example, is trading at a P/E ratio that is very high by historical standards, using it as a benchmark can be hazardous.  

A stock can appear much cheaper than the overall market and still be quite expensive in absolute terms.  So what's an investor to do?  

Unfortunately, there aren't any easy answers.  

The best way to approach stock valuation is by using many different methods, the same way you would if you were valuing a used car or a house.

Checking out what similar houses in a neighbourhood have sold for is akin to relative valuation, and walking through a house you're interested in - looking at the construction and quality of materials - is similar to intrinsic valuation.  

A judicious mix of both methods will serve you well.

Valuing Stocks - Relative Valuation

There are two basic methods of valuing stocks:

• Relative valuation
• Absolute valuation or Intrinsic Valuation

The most frequently used method is relative valuation, which compares a stock's valuation with those of other stocks or with the company's own historical valuations.  

For example, if you were considering the relative valuation for a chemical company CC, you would compare its stock's price/earnings ratio (or its price/sales ratio, etc.) with that of other chemicals makers or with that of the overall stock market.  

• If CC has a P/E ratio of 16 and the average for the industry is closer to, say 25, CC's shares are cheap on a relative basis.  
• You can also compare CC's P/E with the average P/E of an index, such as the S&P 500,  to see whether CC still looked cheap.  

The problem with relative valuations is that not all companies are made alike - not even all chemicals makers.

There could be very good reasons why CC has a lower P/E than its average peer.  

• Maybe the company doesn't have the growth prospects of other chemicals companies.  
• Maybe the possible liability from a product litigation rightly puts a damper on the stock's price.  

After all, a Hyundai has a lower sticker price than a Mercedes, but for very good reasons.

The key is to research your stocks well and be aware of the factors that might justifiably make them cheaper or more expensive than similar stocks.

Common Valuation Ratios

Let's look at the ways in which a stock's price compared with the value of the underlying company can be represented.

Valuations are usually expressed as the ratio of a company's share price to an aspect of its financial performance, such as:

• price/earnings (P/E), 
• price/sales (P/S), 
• price/book value (P/B),
• price/cash flow (P/CF), or 
• price/estimated growth rate (P/EG)

We know that a stock's value is a combination of the company's present condition and its future prospects, and it is usually measured by a series of ratios.

But how do we decide if that value is too high, too low, or just right?

This is where things can get tricky, because valuing stocks is sometimes more an art than a science.  

That's why it is not uncommon for two analysts to look at the same company and come up with different conclusions.

Valuing Stocks - What Is a Stock's Value?

The value of most stocks is a combination of the current value of the company and the value of the profits it will make in the future.

In general, the more growth the market expects from a company, the more the company's market value will owe to expected future profits.  

Take online bookseller YY, for example.  By most measures, company YY has little or no current value; it has only minuscule book value and is gushing red ink.  Liquidating company YY would leave its investors with zilch.  But the market thinks the company's future profit potential is so bright that it has pinned a multibillion-dollar worth (the company's market capitalization) on the stock.

Another way to think of a stock's value is that a company's stock price consists of a combination of what you are paying for the company's current level of profitability and what you're paying for its earnings growth.

Since company YY is far from profitable then,  the stock price is based almost entirely on expectations of future growth.  That is one reason company YY's stock is so volatile.

As those expectations rise and fall, so does the price of its stock.

In comparison, the stock price of another stock XX largely reflects the company's current value, not its future growth.  Company XX is quite profitable, but no one expects it to grow terribly fast.

Valuing Stocks

Valuing a stock is a lot like buying a car.

There are lots of great cars out there, but the sticker price may be more than the actual worth of the car.   Some manufacturers command a premium price because their cars have a certain cachet, not because their cars are necessarily more reliable or of better quality than others on the market.

It is the same thing with stocks.

Some stocks are valued much more richly than others because they are hot or popular with investors, not because the companies are more profitable or have better growth prospects,

The ability to decide whether a company's stock price accurately reflects its performance is the heart of stock valuation.

The Risks of Debt-Driven Returns on Equity

The three levers of ROE are:
- net profit margin  (achieve through operational efficiency)
- asset turnover (achieve through operational efficiency)
- financial leverage (achieve through employing high debt)

But does it matter if a company's high ROE comes from high debt and not operating efficiency?

If a company has a steady or steadily growing business, it might not matter that much.

For example, companies in the consumer-staples sector, where demand is stable, can handle fairly large debt loads with little problem.  And the judicious use of debt by such companies can be a boon to shareholders, boosting profitability without unduly increasing risk.

If a company's business is cyclical or volatile in some other way, though, watch out.

The problem is that debt comes with fixed costs in the form of interest payments.  The company has to make those interest payments every year, whether business is good or bad.

When a company increases debt, it increases its fixed costs as a percentage of total costs.

In years when business is good, a company with high fixed costs as a percentage of total costs can make for a great profitability because once those costs are covered, any additional sales the company makes fall straight to the bottom line.

When business is bad, however, the fixed costs of debt push earnings even lower.  

That is why debt is sometimes referred to as leverage:  It levers earnings, making strong earnings stronger and weak earnings weaker.

When companies in cyclical or volatile businesses have a lot of leverage, their earnings therefore become even more volatile.  

So the next time you're thinking about profitability, make the distinction between the kind that is internally generated (through operational efficiencies) and the kind that is inflated by debt (through leverage).

You can make a lot of money of stocks of companies structured like the latter, but your return is more assured with stocks of companies like the former.

Financial Leverage - Lever of ROE

The three levers of ROE are net margin, asset turnover and financial leverage.

The third lever of ROE, financial leverage, is a measure of how much debt the company carries.

The way in which raising financial leverage increases ROE is a little less intuitive.

If a company adds debt, its assets increase (because of the cash inflows from the debt issuance) and so does its total debt.

Equity = Assets - Total Liabilities
Assets = Equity + Total Liabilities

Since equity is equal to assets minus total debt, a company can decrease its equity as a percentage of its assets by increasing its debt.

ROE
= Net Profit/Revenue  x  Revenue/ Asset   x   Asset/Equity
=  ROA  x  Asset/Equity

In other words, assets - the numerator of the financial leverage figure - increases, so the overall financial leverage number rises, boosting ROE.

Net Margin and Asset Turnover - Levers of ROE

The three levers of ROE are net margin, asset turnovers and financial leverage.

Not all the 3 levers of ROE are made equal.

The first two levers, net margin and asset turnover, are measures of how efficient a company's operations are.

Increasing net margins - which means a company is turning a larger portion of its sales into profits - will increase profitability.  

A high asset turnover, which expresses how many times a company sells, or turns over its assets, in a year is also a sign of efficiency.

The product of net margin and asset turnover is called return on assets, or ROA, and it is an excellent measure of operational profitability.

ROA = Net Profit Margin x Asset Turnover

The higher a company's ROA, the better.

Some companies emphasize high net margins to pump up their ROA; others emphasize rapid turnover.  

For example:

Coca Cola KO

Between 1994 and 1998, Coke's net margins averaged 18%.

Coke was able to leverage its strong brand name into higher prices, resulting in fat net margins.

Cott COTTF, a Canadian produce of discount, non-brand-name soda.

Cotts's average net margin was less than 5%.  

Cott, on the other hand, targeted the low end of the market with bargain prices, earning a slimmer profit margin on each sale but (hopefully) moving a lot more merchandise per unit of assets.

Cott's asset turnover during the same period was 1.7, compared with Coke's 1.1.  But that wasn't nearly enough to offset Coke's much higher net margins, and Coke's ROA of 24% trounced Cott's 4%.  

This is not to say that focusing on asset turnover at the expense of margins is always a bad thing.  

Wal-Mart WMT

Wal-Mart WMT has lower margins than most other major retailers because it emphasizes lower prices.  

But Wal-Mart also generates a higher ROA than most of these competitors because it operates so efficiently that its asset turnover is much higher.

In 1998, for example, Wal-Mart''s asset turnover was 2.8, as opposed to 1.1 for old-line retailer Sears S and 2.0 for rival discounter Dayton-Hudson DH.

Levers of ROE

Return on equity, or ROE, is the most common measure of a company's profitability.

But ROE is itself the product of 3 ratios, or levers:

• net margin (earnings/revenues, expressed as a percentage),
• asset turnover (revenues/assets), and,
• financial leverage (assets/equity).

ROE 

= Net Profit Margin x Asset Turnover X Financial Leverage

= Net Profit/Revenue  x  Revenue/Total Asset  x   Total Asset/Equity

= Net Profit/Equity

Multiplying the three levers together gives us ROE, and raising any one of these three levers will increase ROE.