Anyone that has read my recent post The Importance of Having Your Own Investment Strategy will know that I self-identify as part value investor, part dividend growth investor.
This post is going to concentrate on the value investor side of my approach. I’ll go into more detail later, but the fundamental concept is that value investors seek to buy assets (stocks or otherwise) at a price less than their perception of fair value.
The main tool of value investors are valuation metrics, numbers we use to judge the fairness of a company’s market value. The better the valuation metrics appear, the more attractive the investment is.
This post serves as an introduction on how to implement valuation metrics while investing.
A Short History
Value investing was originally popularized by “the father of value investing” Ben Graham in his seminal work Security Analysis. This book, which was co-authored by Graham’s colleague David Dodd, was one of the first books that I ever read about investing. It had a profound impact on my life, which is why I featured it in my post Three Books That Have Shaped my Investment Philosophy.
The fundamental strategy that underlies all value investing is this: buy assets at a price lower than what you think they’re actually worth. This perceived or calculated worth is known as intrinsic value. The difference between margin value and intrinsic value is known as the margin of safety – and the higher the margin of safety, the better.
So that begs the question – how do we know is something is trading at a low price? This is where valuation metrics come into play.
I’m going to explain four major valuation metrics here, and how you can use them to improve your investment results. The metrics are:
- Price-to-Earnings Ratio
- Price-to-Book Ratio
- Earnings Yield
The Price-to-Earnings Ratio (often abbreviated P/E Ratio) is the most commonly used valuation metric, and seeks to answer the following question:
“How much money am I paying for each dollar of this company’s earnings?”
P/E Ratios are readily available with a quick Google Finance or Yahoo! Finance stock quote. For example, if we were to pull a stock quote for Alphabet Inc. from Google Finance:
A quick glance shows that Alphabet has a current P/E ratio of 30.12.
It’s important to understand where these numbers come from, since we might not always have access to the Internet. In the good old days, investors calculated P/E ratio using financial statements and a calculator – so I’m going to show you how to manually calculate the P/E Ratio. We’ll need to look at the Income Statement and the Balance Sheet of the company under scrutiny.
Let’s use Fairfax Financial Holdings Ltd. as an example. Pulling up their financials on Google Finance, we look at their quarterly income statements. Here we will be calculating a Price-to-Earnings ratio based on trailing-twelve-months (TTM) earnings. So sum the most recent four quarters of Diluted Normalized EPS from Fairfax’s income statement – that gives the “earnings” portion of their Price-to-Earnings ratio.
Fairfax’s TTM earnings is 29.08, partially hurt by a poor quarter at the beginning of this calendar year where they posted a loss of $2.79 per share.
The price portion is easy – simply do a stock quote on Yahoo! Finance or Google Finance. Fairfax is currently trading at $738.26. This gives them a Price-to-Earnings ratio of 25.39.
Notice that this doesn’t match the P/E Ratio provided by the Google Finance stock quote:
This is because there are numerous formulas that can be used to calculate P/E Ratio, and they are all correct. The formulas vary because they use different inputs (particularly earnings) depending on what is considered important by the analyst. Commonly used earnings metrics are TTM earnings, forward earnings, and most-recent-quarter (“MRQ”) earnings multiplied by four (for non-cyclical businesses only). Price input rarely varies, though I have heard of investors using a moving average of stock price.
Similar to the P/E Ratio, the Price-to-Book (or P/B) ratio seeks to answer a fundamental question about the valuation of a company. The question is:
“How much money am I paying for each dollar of this company’s book value?”
Book value per common share (BVPCS) is an accounting measure used to gauge the assets attributable to each common shareholder. It’s calculated using a relatively simply formula:
BVPCS = (Total Shareholder Equity – Preferred Equity)/(Total Outstanding Shares)
In practice, calculating the book value means you need to look at a company’s balance sheet. My preferred way to do this is using Google Finance. I’m going to show you how to calculate Book Value per Share for the Royal Bank of Canada, using their most recent financial quarter.
First, pull up their balance sheet on Google Finance. For the purpose of this analysis, I’ll be looking at the balance sheet from July 31, 2016. There are three line items required to calculate book value per common share. The line items and their values are:
- Total Equity: $69,253.00
- Preferred Stock – Non-Redeemable, Net: $6,712.00
- Total Common Shares Outstanding: $1,482.14
So book value per common share can be calculated as:
($69,253.00 – $6,712.00)/$1,482.14
Which gives a book value of $42.20.
Once you have calculated Book Value per Common Share, it’s really easy to calculate the P/B ratio. Just divide the market price of the common stock by the book value per common share.
For our RBC example above, the current market price of the stock is $80.24, which gives a Price-to-Book ratio of 1.9.
So just like the P/E Ratio provides a sense of value based on earnings, the P/B Ratio provides a sense of value based on assets.
Earnings yield is a metric not often used by investors, but I find it helpful so I’m going to share it anyway. Because it’s uncommon, I’m not going to spend much time on it here.
Earnings yield is calculated as earnings per share divided by market price. You may have noticed that earnings yield is the inverse of P/E ratio – you are correct.
One of the reasons that I like earnings yield is because it is very comparable to dividend yield. By expressing them both as percentages, you can get a sense of how much of a company’s earnings are paid out as dividends. This metric is called payout ratio – dividends paid divided by total earnings.
This metric is full of acronyms, so some explanation is necessary before I can explain why it’s useful.
EV stands for Enterprise Value, which is a measure of the total value of a company that is often used as an alternative to market capitalization. Enterprise Value is calculated as:
Market Value of Common Stock + Market Value of Preferred Stock + Market Value of Debt – Cash & Cash Equivalents
EV is often viewed as the theoretical takeover price if a company were to be acquired in full. That’s why we sum all the marketable securities (common stock, preferred stock, and debt) and we subtract the cash. Cash isn’t really considered in part of the takeover, since paying cash for cash isn’t really considered a cost. Think about it – if someone asked you for a $100 cheque to buy a $100 bill, you’re not going to think you’re actually spending any money.
Now that we understand the top part of the ratio (EV), what about the bottom?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is often used as an alternative to earnings, to adjust for the differences of the cost of doing business in different industries.
Personally, I am not a fan of using EBITDA, because the implication behind doing so is that interest, taxes, depreciation, and amortization are not real expenses and should not be considered in the decision of whether to invest. Obviously this isn’t true. Ask any Canadian taxpayer and I’m sure they will tell you that taxes are a very tangible expense. It’s no different in the business world. I take this stance alongside Warren Buffett, who famously said:
“We’ll (Berkshire Hathaway) never buy a company when the managers talk about EBITDA. There are more frauds talking about EBITDA. That term has never appeared in the annual reports of companies like Wal-Mart, General Electric, or Microsoft. The fraudsters are trying to con you or they’re trying to con themselves. Interest and taxes are real expenses. Depreciation is the worst kind of expense: You buy an asset first and then pay a deduction, and you don’t get the tax benefit until you start making money. We have found that many of the crooks look like crooks. They are usually people that tell you things that are too good to be true. They have a smell about them.”
EV/EBITDA can be used as an alternative to P/E Ratios under the proper circumstances.
How to Implement Valuation Metrics While Investing
I’m now going to explain how to properly implement valuation metrics while investing, since you now know the four major ones. I have two main tips I’d like to share before finishing off.
First of all, make sure that you are using valuation metrics for comparison purposes only. Stating that Apple has a P/E Ratio of 25 is useless unless we have some benchmarks to compare it to. It’s similar to telling someone you weight 100 – 100 what? Pounds or kilograms?
While comparing valuation metrics, ensure that you’re doing so intelligently. It makes no sense to compare the P/E Ratio of a real estate business like Dream Office REIT to the P/E Ratio of an energy delivery company like Enbridge. For various reasons, certain industries tend to be expensive based on earnings (leading to a high P/E Ratio) while others are cheap (low P/E Ratio). Similarly some industries are expensive based on assets (high P/B Ratio) while others are cheap (low P/B Ratio).
My second term is more of a warning – be careful of investing in companies with terribly low P/E Ratios. While the phrase “even the best company can be a poor investment at a high enough price,” is certainly true, I do not believe the contrary to be true. More specifically, I do not believe that “even the worst company can be a good investment at a low enough price.”
If a company is trading at a dramatically low valuation, there is likely a reason for this. Make sure to do some serious due diligence before investing in these situations. If nothing surfaces, then you may have found a serious bargain, but you can never be too cautious.
Readers, how do you currently implement valuation metrics while investing in the stock market? Are there any common metrics that you use that I haven’t included in this list? What’s the cheapest stock that you’ve ever purchased? Let me know in the comments section!