Not having the confidence that they know the true worth of their stocks, is one of the most common laments expressed by many individual investors. Even more importantly, knowing the price of all their stocks, but not knowing their value, is often a major source of shareholder losses. Expressed differently, when you don’t know the value of what you own, it’s very easy to be taken advantage of. It’s an undeniable fact, that people are emotionally attached to their money. Therefore, it’s no wonder that all the price volatility accompanying an often irrational stock market can be quite unnerving. As a result, investors often buy when they should sell, and sell when they should buy.
Making matters even worse is the reality that there is no precise or absolute calculation of intrinsic value or what we like to call true worth. This stems from the fluid nature of a business where future prospects can rapidly change. Think financial stocks in late 2006, going into 2007 and 2008. Once apparently very healthy and profitable enterprises, the fortunes of many financials collapsed with a vengeance. The following earnings and price correlated F.A.S.T. Graphs™ on Citigroup Inc. (NYSE:C) provides a vivid portrayal of how quickly a company’s prospects can change. On the other hand, as frightening as this is, it is very rare to see the fortunes of a company or industry change so dramatically and as fast as we saw with the financial industry. But clearly it can happen, which makes a strong case for diversification.
Perhaps one of the most interesting aspects of the Citigroup Inc. (NYSE:C) example is that the company’s stock price actually correlated to its intrinsic value based on earnings throughout this 20-year history. In other words, where earnings went, stock price followed, and even more importantly, whenever price deviated, over or under, from fair value (the orange earnings justified valuation line in the graph), it quickly came back into alignment. But obviously, although the price adjusting to earnings in 2007 and 2008 was rational, it was horrific at the same time. Nevertheless, the principles of valuation held true in this example and will be elaborated on later in this article.
What Is Fair Value and How Can I Calculate It?
As we stated earlier, there is no absolute or perfectly precise calculation of fair value. However, that does not mean that attempting to determine fair value is an impossible exercise. Quite the contrary, the prudent investor can, easier than many people believe, calculate a reasonable range of fair valuation that they can use to make sound and smart long-term investing decisions. The only reason that fair value cannot be calculated with absolute precision is because part of the calculation must be based on estimates relating to future time.
Moreover, the rational and intelligent investor recognizes that although estimates of future fundamentals such as next year’s or next quarter’s earnings might not be perfect, they also recognize that they don’t need to be. Instead, future earnings estimates only need to be good enough to make a decision that is economically sound. Because, the rational and intelligent investor also realizes that since Mr. Market often behaves irrationally, that perfect tops or bottoms are rarely achieved except by chance. Therefore, instead of seeking perfection, investors must accept a reasonable range of probabilities that offers a high potential for success.
But perhaps the most important aspect of fair valuation is that it is only one component, albeit a very important component, for determining your long-term potential return from owning a common stock. The second important component is the rate of change (growth rate) of the earnings of the respective company you are analyzing. This leads me to another important refinement that adds insight to the relevance and importance of valuation. True worth, intrinsic value or fair value, no matter what you choose to call it, all refer to the same concept. However, it’s important to understand that fair value is a present time metric, whereas the earnings growth rate is more applicable to future time.
The notion that fair value is a present time metric is based on the following, and often misunderstood relevance of fair value, as it applies to making a sound investing decision. At its core, the fair value of a common stock relates to what you are paying to buy a current dollar’s worth of the company’s earnings. From this perspective, fair value depicts the current earnings yield that the investor is receiving on their capital. The most common PE ratio that depicts fair value for most companies is 15, which represents a current earnings yield of 6% to 7% (the actual number is 6.666%, but somehow my Christian upbringing precludes me from stating so). Put another way, this is more or less the average earnings yield for the average publicly-traded company.
To clarify even further, let’s review two companies through the lens of F.A.S.T. Graphs™ where both demand a current fair value PE of 15, however, each respective company has significantly different historical earnings growth rates. In both examples, the current fair value PE ratio of 15 applies regarding making a sound current investment decision. However, the rate of change of earnings growth will have a material impact on future earnings power, and therefore, future long-term return potential.
Our first example will look at Church & Dwight Co., Inc. (NYSE:CHD) an above-average growing supplier of household products. With this fast growing company, we only have to look back to calendar year 2003 to illustrate fair value as one component of return versus rate of change of earnings growth as our second component. At the beginning of 2003, Church & Dwight Co., Inc. (NYSE:CHD) was trading at approximately a PE ratio of 15 which calculates our 6% to 7% fair value earnings yield. In other words, this represented a sound valuation to pay for this above-average growing company.
In this example, assuming that we bought the stock in January of 2003, we acquired $.61 worth of earnings at an approximate PE ratio of 15. This purchase represented our fair value current earnings yield of 6% to 7% based on the current earnings we purchased. However, thanks to the power of compounding, and utilizing the Rule of 72, we are purchasing a stock whose earnings are doubling approximately every five years. Therefore, although we are buying current earnings at fair value, we are buying 5-year future earnings at a bargain PE ratio of approximately 7.5, or half the cost of our original earnings, thanks to the doubling approximately every 5 years. Note through the green highlights at the bottom of the graph that our original $.61 of earnings grew to a $1.27 worth of earnings by year-end 2007 (in essence a doubling).
With our second example, we look at a slower growing utility stock, SCANA Corporation (NYSE:SCG) whose historical earnings growth has only averaged 3% per annum. At this rate of earnings growth, again using the Rule of 72, it takes approximately 24 years for this company to double its earnings. Unfortunately, our graphing tool only offers data going back approximately 21 years to 1993, nevertheless, we can see that after 21 years, earnings have yet to double.