Introduction on Stock Valuation
When it comes to writing about investing in common stocks, my favorite theme typically revolves around valuation. In fact, I once had a reader dub me “Mr. Valuation.” Which, I might add was very flattering to me. Moreover, in the context of discussing valuation there are normally three concepts that are included. They are typically fair valuation, undervaluation or overvaluation.
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Oh, but would it not be wonderful, if everything about valuation were that simple. In truth, the concept of valuation is much more complex than those three simple notions. Therefore, one of the primary objectives of this article is to broaden the reader’s perspectives and understandings of the incredibly important concept of valuation as it relates to investing in common stocks.
However, before I delve too deeply into this subject, I would like to offer these following positioning statements. Position number one, just because a stock is technically trading at fair value, does not necessarily mean that it is a good or attractive investment. Position number two, just because a stock is moderately overvalued, does not necessarily mean that it is a poor or unattractive investment. In truth, there are circumstances where a moderately overvalued stock is actually a much better investment than a stock that is fairly valued. The key, as will be discussed later, revolves around the potential growth of the respective company.
The reason that the above positioning statements are true and valid is because valuation is only one component of many relating to common stock investment returns. There are many other factors such as the earnings growth rate of the stock in question, past, present and future, that will impact the future total return. Whether a company pays a dividend or not, and the level of the dividend it pays, if it does pay one, is also very important.
Therefore, to summarize, valuation is but one important component of successful stock investing. Furthermore, I would argue that valuation is more relevant to the soundness of the investment than it is to the total return the investment is capable of achieving. This is why (and I will elaborate more on this later on in the article) two companies with vastly different growth rates can technically be fairly valued with the same PE ratio. However, the potential future performance of each can be materially different as a function of each respective company’s growth potential.
A Conceptual Definition Of Fair Value
If you look up the term fair value on sites such as Investopedia or Wikipedia and others, you will discover what I believe are vague and even somewhat esoteric definitions. Therefore, I believe it is important that I offer my own definition of fair value so that the reader can at least be cognizant of the precise concept I am referring to. To me, fair value, as it relates to common stock investments, is manifest when the current earnings yield provided by the company’s profits, compensate me for the risk I am taking by providing both a realistic and acceptable return on my invested capital.
When referencing my definition of fair value, it’s important to focus on the concept “current earnings yield.” There a couple reasons why I feel this is both rational and important. First of all, the current earnings of a given business are typically precisely known (reported earnings). Therefore, the calculation of the return that the current earnings are offering me can be accurately calculated. To clarify a little farther, after years of extensive research and experience, I have determined (or at least satisfied myself) that a PE ratio of 15 represents fair valuation for the majority of companies based on realistically achievable growth rates.
In addition to the fact that after examining thousands of companies over several decades, through the lens of the FAST Graphs™ (Fundamentals Analyzer Software Tool), I have observed that a 15 PE ratio represents historical fair value for earnings growth up to 15% per annum. There are other logical facts that also support a 15 PE. First, I believe that it is not a coincidence that the more than 200-year average PE ratio of the S&P 500 is 15. Second, this is a fact because I believe it also represents, and is consistent