What is value and when is a stock or the market cheap?
In this week’s video insight Roger discusses the importance of being able to value a company, and the importance of having a framework for thinking about when a company or the stock market might be cheap. That framework should be able to help you navigate through the markets various storms and sunny periods.
When I spoke to you last week I proposed the idea that the market had set itself up for potential disappointment. I don’t know whether the market is going to fall or continue falling or rise next week, the week after, or the week after that. But I do know that if you focus on quality, the other subject of last week’s video, and value, you’ll do well.
The second part, value is the more challenging part of investors to follow in a disciplined way, because it requires patience. It requires standing aside sometimes when the market surges ahead. So what is value and when is a stock or the market cheap?
Well, there’s no right answer to that. There are multiple models for determining value. There’s excess return models, two stage models, H-models, some of the parts models. There’s so many different ways. And even price-to-earnings (P/E) ratios. So many different ways to estimate the value of a business.
What is important is that you have a framework for thinking about when a company or the stock market might be cheap. That framework should be able to help you navigate through the markets various storms and sunny periods. Without knowing what the market’s going to do next, you can still have some confidence that you are buying at a great price.
Now, some of you may not have seen our recent blogs on this subject so I want to talk to you about it for those that prefer to listen rather than read. If I buy and sell a stock on the same P/E ratio, whether it be over three years or four years or five years, whatever the period is. If I buy that stock on a P/E of 10 and sell it on a price-to-earnings ratio of 10, my return will equal the earnings per share growth rate of that particular company.
So if the earnings per share are growing at 15 per cent and I’ve bought the stock on a P/E of 10, and in five years time, I sell it on a P/E of 10, then I will receive an IRR, an internal rate of return of 15 per cent. Now, why is that important?
Well, number one, recently back in June, stocks became very cheap simply because all of the collapse in the share price was related to P/E compression. P/Es came down, but the earnings for many companies did not. And last week you might remember, I spoke about REA Group, a business that even in the face of intense competition manages to be able to lift its price and continue to generate rising revenues and rising profits. So finding those quality businesses that are going to grow their earnings over the next three, four or five years is vital.
But coming back to the question about value, P/E ratios are not necessarily a measure of value. They are a measure of the popularity of the stock market. Now, in terms of a very simple framework, Warren Buffett suggested to us, be greedy when others are fearful and fearful when others are greedy. P/Es represent the popularity of stocks or the popularity of the stock market. So if P/Es compressed by 30, 40 or 50 per cent, you can be fairly certain that stocks have become unpopular. And it might just be time to sharpen the pencil.
Taking the framework one step further, what if over the next five years after we’ve bought when stocks were unpopular, they became popular again? And they will. Well, your return will be much better than the earnings growth rate of the company, because you’ll also collect the profit from the re-rating of the stock. And finally, can we be comfortable buying if the P/Es dropped 50 per cent, knowing that it might fall even further?
Well, let me give you one simple example. If you buy a company whose earnings per share grow by 15 per cent per year over the next five years, if the P/E doesn’t change, your return will be 15 per cent. If however, the P/E compresses by a quarter, by 25 per cent, your return over five years will be 9 per cent per year if you continue to hold that company whose earnings per share are growing at 15 per cent per annum. And finally, where do you start losing money owning this business on a P/E ratio of say 10 that grows its earnings at 15 per cent per year? Well, you don’t start losing money from that investment until the P/E contracts by more than 50 per cent. If the P/E contracts by 50 per cent, you have to hold the stock for five years and it needs to grow its earnings by 15 per cent per annum for you to break even. Now, it’s very likely that even if the P/E contracts by 50 per cent, over five years, it will probably go back up again.
So that’s an idea for a framework for thinking about P/E ratios or thinking about value, whatever way you want to value companies, but knowing that there’s a great buffer if you’re buying businesses that are growing strongly. So stick to quality, as I said last week. Look for value, as we’re talking about this week. And next week, we’ll add a final element to this trifecta of investment insights.
Read my previous blog on this topic: