Valuation critical to earning hefty returns

Valuation is critical to ensuring that your careful, competitive analysis pays off in attractive portfolio returns.

Let’s look at price multiples, our first tool.

Multiples are simultaneously the most commonly used and the most commonly misused valuation tool. The most basic multiple is the price-sales ratio, which is just the current price of a stock divided by sales per share.

The nice thing about the price-sales ratio is that just about all companies have sales, even when business is temporarily in the dumps, which makes the ratio particularly useful for cyclical companies or companies that are having some kind of trouble that sends earnings temporarily into the red.

The trick with the price-sales ratio, however, is that a dollar of sales may be worth a little or a lot, depending on how profitable the company is. Low-margin businesses such as retailers typically have very low price-sales ratios relative to high-margin businesses such as software or pharmaceuticals.

So don’t use price-sales ratios to compare companies in different industries or you’ll wind up thinking that the lowest-margin companies are all great bargains, while the high-margin ones are too expensive.

In my opinion, the price-sales ratio is most useful for companies that have temporarily depressed margins or that have room for a lot of improvement in margins. Remember that high margins mean more earnings per dollar of sales, which leads to a higher price-sales ratio.

So if you run across a low-margin company with a price-sales ratio in line with similar low-margin companies and you think the company can cut costs and boost profitability significantly, you might have a cheap stock in your sights.

In fact, one useful way to use the price-sales ratio is to find high-margin companies that have hit a speed bump. Companies that have been able to post fat margins in the past but that have low price-sales ratios may be discounted by the market because other investors assume the decline in profitability is permanent.

If in fact the company can return to its former level of profitability, then the stock is probably quite cheap. This is one use for which the price-sales ratio can be a better tool than the price-earnings ratio; the p/e ratio on a stock that is underearning its potential would be high (because earnings are low), so looking for a low p/e ratio wouldn’t uncover these kinds of out-of-favor stocks.

HITTING THE BOOKS

The second common multiple is the price-book ratio, which compares the company’s market price with its book value, which is also called shareholders’ equity. Think of book value as representing all the physical capital invested in the company, [such as] factories, computers, real estate, inventory, you name it.

The rationale for using book value in certain cases is that future earnings and cash flows are ephemeral, while the stuff that a company physically owns has a more tangible and certain value.

The key to using the price-book ratio in valuing stocks is to think carefully about what “book” represents. Whereas a dollar of earnings or cash flow is exactly the same from company A to company B, the stuff that makes up book value can vary dramatically.

For an asset-intensive firm such as a railroad or a manufacturing firm, book value represents the bulk of the assets that generate revenue, [for instance] things such as locomotives, factories and inventory. But for a service or technology firm, for example, the revenue-generating assets are people, ideas and processes, none of which are generally contained in book value.

Moreover, many of the competitive advantages that create economic moats (structural characteristics that are inherent to a business) are typically not accounted for in book value. Take Harley-Davidson [Motor Co. of Milwaukee] as an example, which has a price-book ratio of about 5 as of this writing, meaning that the company’s market value is about five times the rough net worth of its factories, land and inventory of yet-to-be-built motorcycle parts.

That seems pretty rich, until you consider that the value of the company’s brand name is not accounted for in book value, and it’s the brand that allows Harley to earn 25% operating margins and a 40% return on equity.

There is one other quirk to book value worth knowing.

It can often be inflated by an accounting convention known as good will, which is created when one company buys another. Good will is the difference between the acquired company’s tangible book value and the price paid for it by the buyer, and as you can imagine, it can be a huge number for firms without a lot of physical assets.

When [AOL LLC] bought Time Warner [Inc., both of New York], the book value of the combined firm increased by $130 billion in goodwill. The trouble is, good will often represents little more than the desire of the acquiring firm to buy the target before someone else does, and so its value is usually debatable, to say the very least.

You’re best off subtracting good will from book value, and often when you see a price-book ratio that seems too good to be true, it’s because a big goodwill asset is boosting book value.

So, with all these pitfalls, why bother with book value? Because it is extremely useful for one sector of the market that contains a disproportionate number of companies with solid competitive advantages: financial services.

The assets of a financial company are typically very liquid (think of the loans on a bank’s balance sheet), so they are very easy to value accurately, which means that the book value of a financial services company is usually a pretty decent approximation of its actual tangible value. The only caveat here is that an abnormally low price-book ratio for a financial firm can indicate that the book value is somehow in question, perhaps because the company made some bad loans that will need to be written off.

As you have no doubt guessed by now, every price multiple has a good side and a bad side, and the mother of all multiples, the p/e ratio, is no different. P/E ratios are useful because earnings are a decent proxy for value-creating cash flow and because earnings results and estimates are readily available from just about any source you care to name.

They are tricky, though, because earnings can be a noisy number and because a price-earnings ratio doesn’t mean a whole lot in a vacuum: A p/e ratio of 14 is neither good nor bad, unless we know something about the company or we have a benchmark against which to compare the ratio.

Of course, one of the trickiest aspects of the p/e ratio is that while there may be only one “P,” there may be more than one “E.”

I’ve seen p/e ratios calculated using earnings from the most recent fiscal year, the current fiscal year, the current calendar year, the past four quarters and estimates for the next fiscal year. Which one should you use? That’s a tough question. Always approach a forecasted earnings number with some caution.

These forecasts are usually the consensus estimate of all Wall Street analysts following the company, and multiple studies have shown that consensus estimates are typically too pessimistic just before a beaten-down company rebounds and too optimistic just before a highflier slows down.

A reasonable-looking p/e ratio of 15 becomes a less reasonable 20 if earnings turn out to be 25% less than expected.

My advice is to look at how the company has performed in good times and bad, do some thinking about whether the future will be a lot better or worse than the past, and come up with your own estimate of how much the company could earn in an average year. That’s the best basis for a p/e on which to base your valuation because No. 1, it is your own, so you know what went into the forecast, and No. 2, it is based on an average year for the company, not the best of times or the worst of times.

Once you have found your “E,” you are ready to use the p/e ratio.

The most common way to use a p/e ratio is to compare it with something else, such as a competitor, an industry average, the entire market or the same company at another point in time.

MERIT TO THE APPROACH

There is some merit to this approach, as long as you don’t go about it blindly and you remember the four main drivers of valuation that I discussed earlier in the chapter: risk, growth, return on capital and competitive advantage.

A company that is trading at a lower p/e ratio than others in the same industry might be a good value, or it might deserve that lower p/e ratio because it has lower returns on capital, less robust growth prospects or a weaker competitive advantage.

The same limitations apply to any comparison of a single company’s p/e ratio with the average p/e ratio of the whole stock market. A company with a p/e ratio of 20 relative to the market p/e ratio of about 18 (as of mid-2007) looks a little pricey; but what if that company is, say, Avon Products Inc. of New York, with a wide economic moat, 40% returns on capital, and robust growth prospects in emerging markets? Hmm, maybe the shares are not so pricey after all.

Similar cautions apply when comparing a company’s current p/e ratio with past p/e ratios. It is common for investors to justify an undervalued stock by declaring, “The shares are trading at their lowest multiple in a decade!” (I’ve done this more than a few times myself.)

All else being equal, a company trading for 20 times earnings that has historically traded for 30 to 40 times earnings sounds like one heck of a deal, as long as it has the same growth prospects, returns on capital and competitive position. But if any of those attributes has changed, then all bets are off. Past performance may not guarantee future results, after all.

Pat Dorsey is a director of equity research at Morningstar Inc. of Chicago.