Price is what you pay; value is what you get (Warren Buffett).
It is important to understand the difference between price and value since it will help us to make the right decisions. Mr. Market puts a price tag on each security. This is happening multiple times in a minute after the opening bell has rung. Stock prices go up, fall or stay flat. At the most fundamental level, supply and demand in the market determine stock price movements. But who are the players behind the supply and demand side? Basically people, human beings. The science has already proven that the behavior of humans is not always rational. Daniel Kahneman, a Nobel prize winner in economics, has done tremendous work in researching human biases. There are dozens of behavioral biases that have an impact on our investment decisions. Loss aversion or overconfidence, just to name a few. Many of these aspects are driven by human characteristics and emotions, such as fear and greed. They can and do affect the price of a stock, sometimes to a large degree but rarely do they significantly impact its value.
Historical and future value calculations
Since the price is not always reflecting the real value of a business, we observe situations where a stock can be overvalued, undervalued or fairly valued. To find undervalued high-quality investment opportunities is a popular strategy for many successful investors. For a good reason. Research indicates that valuation is a key factor in achieving long-term investing success. In other words, it makes great sense to acquire shares that are trading at a discount to its fundamental value.
But how do we know whether a stock is trading at a discount? Well, there are several metrics and methods to measure the fair value of a business – P/E ratios, discounted cash flow, multiples of free cash flow, enterprise value to EBITDA, etc. Some are based on historical value calculations whereas others refer to future value calculations. The past performance, of course, is not always a guarantee for future success. Nevertheless, we observe that businesses that have performed well in the past continue to do very well in the future. The methods which are focusing on future value calculations are often subjective and difficult do predict. The future is always uncertain. But this is exactly what matters to us as investors. We want our holdings to do well in the future and to grow earnings and cash flows for a long time to come. I believe it is senseless to argue that a certain method is superior. All of them can be skillfully utilized to find a good understanding of a companies’ fair value.
Four-step valuation approach
Personally, I like the valuation approach that was introduced by Dave van Knapp at the Daily Trade Alert website (https://dailytradealert.com). In general, I highly recommend taking a close look at the investing lessons published by Dave. There is a huge value in it!
I use the four-step approach to find the fair value estimate of a company:
1) Current P/E ratio VS. historical average P/E ratio of the market
The first method relates the current P/E ratio of the security to the long-term average P/E ratio of the market.
I take Illinois Tool Works Inc. (ITW) as an example for further analysis:
What we can see in the FAST-Graphs picture is that the current P/E ratio of ITW is sitting at 18.1. The long-term market P/E ratio is 15 (orange line).
We use both figures to calculate the price/fair value ratio:
Price/fair value ratio of method 1 = 18.1 / 15 = 1.21
The further the price/fair value ratio rises above 1, the more the stock is overvalued. A ratio of 1 indicates that the stock is about fairly valued. The further it moves below 1, the more the stock is undervalued.
In the case of ITW, the price/fair value ratio results in 1.21. The valuation indicates that the stock price of ITW is 21% overvalued.
2) Current P/E ratio VS. historical average P/E ratio of the security
The second method relates the current P/E ratio of the security to its own long-term average P/E ratio.
Referring to the above example of ITW, we observe the following data:
The “normalized” long-term P/E ratio of ITW is 20.8 (blue line).
One can argue that this is a more appropriate reference point since its valuation in the past was well above the average P/E of the broader market. It is not unusual that some stocks are trading at a premium to the market, simply because the share price reflects a high quality of the business or high earnings growth. Putting in the data, we get the following picture:
Price/fair value ratio of method 2 = 18.1 / 20.8 = 0.87
Using the own long-term PE of ITW, now we see a different result.
We remember from above, the further the price/fair value ratio moves below 1, the more the stock is undervalued.
In the case of ITW, the second method indicates that the stock price is 13% undervalued.
3) Historical average yield VS. current yield
The third method compares the historical average dividend yield (I use the 5-year-average yield) with the current dividend yield. The approach states that a company is undervalued when the current yield is above the historical average and vice versa.
Using the example of ITW, we get the following picture:
The 5-year-average dividend yield is sitting at 1.99%. The current dividend yield is 2.46%.
We set both figures in proportion to find the price/fair value ratio:
Price/fair value ratio of method 3 = 1.99 / 2.46 = 0.81
The further the price/fair value ratio moves below 1, the more the stock is undervalued.
In the case of ITW, the third method indicates that the stock price is 19% undervalued.
4) Morningstar Star Rating
Morningstar, a well-known investment research company, uses a different approach to find the fair value estimate – the discounted cash flow model. The main concept behind DCF is simple: a stock’s value is equal to all its estimated future cash flows discounted to today. In contrast to the previous valuation models, the DCF does not consider historical valuations.
Using the DCF method, Morningstar comes to the following result:
The stock price of ITW is about 8% undervalued. This translates into the following price/fair value ratio:
Price/fair value ratio of method 4 = 0.92
To find the final fair value estimate, we simply build an average of the four price/fair value ratios calculated above:
Method 1 = 1.21 (overvalued by 21%)
Method 2 = 0.87 (undervalued by 13%)
Method 3 = 0.81 (undervalued by 19%)
Method 4 = 0.92 (undervalued by 8%)
= (1.27+0.87+0.81+0.92) / 4
Total price/fair value ratio = 0.95
The four-step valuation approach indicates that the stock price of ITW is about 5% undervalued.
Taking into account the overall valuation grading, one could conclude that Illinois Tool Works Inc. (ITW) is about fairly valued at the current price level.
Two important notes:
1) I just want to outline that any valuation result represents just an estimate. There is no such thing as an objective fair value. Ask ten analysts and the odds are high that they will deliver slightly different estimates. One can argue that a stock price is relatively expensive based on the historical valuation or expected future cash flows. But such statements should not be considered as the ultimate truth.
2) A cheap valuation is not always a trigger to buy. The value approach is not just about acquiring undervalued companies. Businesses of poor quality often carry a cheap valuation. Does the undervaluation of such companies qualify them as a good investment? Most probably not. We target high-quality businesses that are trading at a discount to estimated fair value.