Why Getting Valuation Right Is So Important To Retired Dividend Growth Investors by Chuck Carnevale, F.A.S.T. Graphs

Introduction

Although getting valuation right before you buy a stock is critically important to the long-term oriented retired dividend growth investor, it is not a short-term market timing concept.  My point is that short-term market movements are typically volatile and unpredictable.  The reason is simple.  Over short periods of time, which I define as less than a business cycle (3- 5 years), emotion has a major effect on stock prices.

When dealing with common stock investments, the primary emotions that interfere with reason are fear and greed.  However, there are also subtle nuances associated with these primary emotional responses.  For example, if a stock is running to the upside, investors might feel they are missing out and invest regardless of valuation.  Although this is related to greed, it is a milder form.  Conversely, if a stock is falling precipitously, panic often sets in motivating investors to sell regardless of fundamental strengths.  Panic is related to fear, but it is an extreme form.

This speaks to the reality that between the two primary emotional responses (fear and greed) that investors face, fear is both the most influential and the most dangerous.  In my experience, more money has been lost through panic selling than through overpaying.  This is especially true when investing in high-quality dividend growth stocks with consistent records of above-average earnings growth.  Again, the reason is simple.

When the emotional response kicks in, logic and reason is often disregarded and people can mistakenly buy when they should be selling and/or sell when they should be buying.  Sometimes this works out okay in the short run, but in the long run it usually ends up creating poor, and in some cases, disastrous results.  If you overpay for a growing business, you face the prospect of earning less than the company’s earnings growth would produce if you were more prudent.  However, if the business is truly growing, you might still make money even though it is most likely less than you should have made.

In contrast, if you sell a valuable business for less than it is worth based on fundamental strengths, you turn an unrealized and usually temporary loss into a true, permanent and realized loss.  This is just one reason why fear is a more dangerous emotional response than greed.

Valuation – What It Is and How It Works

Fair valuation is a metric that astute fundamental investors focus on to ensure that they are making a prudent investment decision when considering a stock to purchase.  However, it is not a metric that is driven by short-term stock price movements.  In other words, valuation is not concerned with price momentum in either direction up or down.  At its core, valuation relates to a company’s past, present and potential future earnings power in relation to the price you are being asked to pay to buy it.

In this context, fair valuation relates to the earnings yield that an investment in a stock offers based on its current price in relation to the company’s earnings and/or cash flows.  A common valuation measurement that many investors rely on is the P/E ratio.  However, the P/E ratio metric simply serves as a quick guide for determining earnings yield.  Earnings yield can be calculated simply by inverting the P/E ratio to an E/P ratio (earnings divided by price).

When investing in common stocks, astute fundamental investors require an earnings yield of at least 6.5% to 7% or better.  Of course, the higher the earnings yield you can purchase a stock for, the better.  Importantly, this number is not simply pulled out of a hat.  Instead, it relates to the average return that stocks have generated for investors over the long run.  A shortcut formula for determining earnings yield is to simply divide the number 1 by a company’s current P/E ratio.

A few simple examples will clarify how this works.  A P/E ratio of 15 (the historical norm for the S&P 500) calculates to an earnings yield of 6.67% (1÷15 = 6 .67%).  In contrast, a P/E ratio of 20 calculates to an earnings yield of 5% (1÷20 equal 5%), which would be below the 6.5% to 7% required minimum threshold.  A high P/E ratio of 30 only calculates to an earnings yield of 3.33% (1÷30 = 3 .33%), which is obviously half of the earnings yield represented by a P/E ratio of 15.

In the real world also known as the stock market, it is not uncommon to see stocks grab momentum and move from fairly valued P/E ratios in the 15 range, to valuations of 20 or 30 times earnings for a short period of time.  There are many high-quality dividend growth stocks that are currently trading at such heights with no material improvements in fundamentals to justify their valuations.  However, when valuations are not supported by fundamentals, investors are exposed to the potential fickle results that can occur when popularity wanes.

In stock market parlance, valuations not supported by fundamentals are referred to as hot potato stocks.  As an investor, you can do well by investing in a hot potato stock as long as you pass the potato on to the next person while it is still hot.  You don’t want to be the person getting the hot potato just before it cools off.  The problem is that momentum is fragile because investor sentiment can change in a heartbeat.  On the other hand, strong fundamentals are substantial because this is where the true value of a business is found.

To summarize the essence of valuation, when you overpay for even a great stock, you are taking more risk than prudence would dictate.  Consequently, in reality you are exposing yourself to returns that are lower than the strength of the business would offer at more prudent valuations.  In contrast, when you are given the opportunity to purchase a fundamentally strong business below sound valuation, you are simultaneously taking on less risk while generating the potential for returns higher than the growth of the business would offer.

This higher return manifests as the P/E ratio increases to fair valuation levels which serves as natural leverage.  To clarify, you originally buy earnings at a lower P/E ratio, then future earnings grow to higher levels and therefore those higher earnings are capitalized at a higher multiple.  I call this natural leverage.

Digital Realty Trust Inc: Quintessential Lessons on Valuation

On June 30, 2013 fellow Seeking Alpha author and friend Brad Thomas penned an article on Digital Realty Trust Inc. found here at a time during which its stock price had fallen approximately 22% from highs established one year earlier (July, 2012).  Brad’s positive article on Digital Realty (DLR) was mostly met with skepticism and some support.  You can read the comment section of the article to validate my previous statement.

However, the primary point I am offering is that Digital Realty was an unpopular stock and there were even hedge funds recommending shorting it.  In the short run, some of the negativity was validated as Digital Realty’s stock price dropped another 22% over the next 5 months (November 29, 2013).  But most importantly, Digital Realty was in truth undervalued when Brad Thomas originally wrote

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