Chapter 5: Valuate Quality Company Stock Prices
Chapter 5: Valuate Quality Company Stock Prices
Book Serialization | Quality Value Investing: How to Pick the Winning Stocks of Enduring Enterprises
Welcome to Chapter 5 of the draft manuscript serialization of my next book, Quality Value Investing: How to Pick the Winning Stocks of Enduring Enterprises.
I am writing the book on Substack Finance as part of the QVI Newsletter and look forward to subscribers’ support and feedback as we produce the manuscript in real-time.
Chapter 5 explores select valuation metrics to analyze and weigh the intrinsic present value or margin of safety of the common shares of targeted quality enterprises.
The chapter focuses on four preferred and three alternative valuation multiples.
Chapter 5
Valuate Quality Company Stock Prices
Quality at value matters in every area of our financial lives, including the stock market.
Quality-driven value investors focus on stock price attractiveness as a prerequisite to preserving invested capital.
Preferred valuation multiples include price-to-sales, price-to-trailing earnings, price-to-operating cash flow, and enterprise value-to-operating earnings.
In addition, there are several alternative, albeit more speculative, valuation ratios.
The Quality-Driven Value Strategy
A primary tenet of searching for stock investing nirvana or alpha is determining the attractiveness of a stock price based on valuation multiples relative to the business’s fundamentals.
Successful quality-driven value investors on Main Street uncover asymmetric price/value opportunities without the need for the typical Wall Street prerequisites of predictive analysis and business modeling overkill. Instead, they target due diligence on key fundamental strategic areas of the business.
Too many market pundits believe in predicting future price movements with abandon. Their proverbial crystal ball—disguised in the sophisticated clothing of technical charts, trends, and assumptions—wreaks havoc on the portfolios of unsuspecting investors modeling speculative market plays. Quality-driven value investors avoid predicting exact stock price or percentage changes, whether one, three, or five years from now and never mind next week.
For value-driven investors, an attractive stock price becomes a nonnegotiable prerequisite to initiating the productive partial ownership of a quality company. And the preservation of invested capital becomes supreme following the stock purchase.
On a mission to keep investing super simple, I rely on just four multiples serving as indicators or measurements of the potential mispricing of the stock. For example, my focus is on the financial vertical of revenue, earnings, cash flow, and enterprise value. This chapter also peeks at a few more, albeit speculative, valuation alternatives.
In the recent volatile, cash-rich, tax- and previously interest-rate-advantaged epic bull market, companies with generous shareholder yields and high capital allocations from management were commonplace. However, finding quality operators with compelling valuations remained challenging in the 2022 inflationary bear market and continued during the 2023 bullish recovery.
A fundamental premise of this chapter is the potential for increasing annualized compounding total returns on capital and dividends when purchasing common shares with wide safety margins. Savvy investors seek a price point below the general estimate of the company’s intrinsic value, as represented by the underlying stock.
Investors contemplating the specific stock price at any given time can take the easy road and buy or sell speculative and risky options and futures. However, as with any casino, good luck with those house-advantaged games.
Again, quality-driven stock investors on Main Street refuse to interpret the Wall Street consensus as a definitive buy or sell signal. Nevertheless, evaluating market sentiment on a stock can be an earnest dive into a contrarian’s treasure trove.
The market consensus estimates the combined unanimity on a stock by analysts, bloggers, portfolio managers, retail investors, employees, and other stakeholders. Contrarians assume the crowd is wrong regarding the company’s longer-term prospects. Although additional research is necessary to confirm or contradict the accord, the consensus is often a counterintuitive indicator for quality-driven value investors.
A confident calculation of the margin of safety provides a good measure of a company’s intrinsic worth based on recent or trailing indices as opposed to assumptive future cash flows and other crystal ball projections. Thus, gauge the present value of a targeted holding for longer-term, alpha-seeking investing instead of shorter-term cigar butt trading.
Preferred Intrinsic Value Indicators
The QVI Real-Time Stock Picks contain companies trading on major US exchanges—none are micro-caps or over-the-counter issues—meeting initial quality tests such as a competitive value proposition, management effectiveness, Treasury-beating shareholder yields, and acceptable levels of enterprise and share price downside risks, discussed further in Chapter 6.
As essential, the representative stocks were trading at sensible prices per the preferred valuation multiples at the time of purchase. Primary tickers held in the portfolios or on a watchlist are subject to further research to verify which companies, if any, are worthy of initial or continued partial ownership.
Consider an investment strategy combining quality and value as the best opportunity to generate compounding total return over an extended holding period. Here are the preferred valuation multiples used to build and monitor QVI’s alpha-achieving stock picks.
Price to Sales
The price-to-sales or P/S ratio measures the stock price relative to revenue.
Price-to-sales is the previous market day closing price divided by the sales per share over the trailing twelve months or TTM. Interpret two times or below as an attractive multiple—or at least a P/S ratio lower than the industry and sector median averages—when valuing a stock price relative to its revenue stream.
As a former executive, I have long held that improved revenue often solves a business’s financial problems more than cost-cutting. When the market underestimates net revenues in the context of the stock price, a potential buying opportunity for a quality operator presents itself.
The price-to-sales ratio is perhaps the best barometer of intrinsic value because revenue drives earnings.
Earnings are subject to stringent accounting rules and massaging by management—revenue less so—and thus, justify a more substantial weighting of the P/S ratio, including comparables to industry peers of the targeted company.
Price to Trailing Earnings
The price-to-trailing earnings, or P/E ratio, is the perennial valuation multiple in the investing universe.
Price-to-earnings is the closing stock price divided by the sum of GAAP diluted earnings per share or EPS over the trailing twelve months. Interpret below 20 times as an attractive multiple—or at least a P/E ratio lower than the industry and sector median averages—when valuing a stock price relative to its EPS.
As discussed in Chapter 4: Calculate Shareholder Yields, the inverse of P/E or earnings yield—trailing earnings per share divided by the stock price—helps quantify the equity bond rate of the stock as compared to the US Ten-Year Treasury note.
Nonetheless, of the four select valuation multiples used in the QVI Stock Picks, the least weight is placed on the P/E ratio when estimating the intrinsic value of a stock price because of management’s propensity to massage earnings outcomes, albeit legally.
Price to Operating Cash Flow
Quality-driven investors frequently interpret favorable cash flow multiples as a leading intrinsic value indicator.
The price-to-operating cash flow or P/CFO ratio is the closing stock price divided by cash flow per share for the most recent fiscal year. Measuring cash flow multiples provides a reliable interpretation of the intrinsic value of a stock price. Look for stocks trading at single-digit multiples to the operating cash flows or at least below the sector and industry median averages for the best value.
Operating cash flow represents the cash available from net income. Remember that per accounting rules, operating cash flow can be higher, equal, or lower than net income based on the allowable adjustments used by senior management.
Quality-driven investors also use price-to-free cash flow or P/FCF ratio when weighing valuation multiples. Also introduced in Chapter 4, free cash flow is operating cash flow after capital expenditures.
Price-to-operating cash flow can be a more reliable valuation metric than P/FCF because of the potential subjective interpretation of free cash flow. Nevertheless, quality-driven value investors should use P/CFO for consistency and metric availability. Cash is king—or queen—and whenever the market discounts cash flow in the stock price of a quality operator, value-driven investors notice.
As a net product of the earnings vertical, operating cash flow acts as a more reliable indicator of value in the context of earnings quality than earnings per share. If P/E is the big picture, then P/CFO is the nuts and bolts of the company’s earnings quality in senior management’s ability to effectively allocate after-tax profits to working and invested capital.
Enterprise Value to Operating Earnings
Enterprise-value-to-operating earnings or EV/EBIT demonstrates how the company’s operating profit aligns with market-wide investor interest.
EV/EBIT is market capitalization plus debt, minority interest, and preferred shares minus total cash and cash equivalents or EV, divided by operating earnings or earnings before interest and taxes or EBIT.
Screen for stocks appearing undervalued in the context of the corporation’s operating earnings. For example, less than 15 times EV/EBIT reflects an attractive stock price. Moreover, EV/EBIT offers a useful contrarian sentiment indicator of whether the crowd has overbought a stock, as indicated by the higher multiple, or has oversold shares, as reflected in the lower multiple.
Investing in stocks concerns company earnings and the potential cash flow it generates. As a result, the crowd tends to pay fair market value or overpay when buying common shares. More often, speculators and algorithms, sparked by breaking news, rumors, quarterly reports, or other short-term catalysts, create rare opportunities by overselling the mispriced stocks of quality operators.
Investors can gain a good measure of market sentiment on a stock by evaluating the enterprise value to operating earnings. Then, astutely pounce on the sudden marked-down equity merchandise waiting in their financial shopping cart, whether buying off a watchlist or adding additional shares to a portfolio holding.
Alternative Valuation Multiples
Three supplemental ratios are commonplace in valuing stock prices. However, in practice, place less weight on these more speculative and less reliable pricing models.
Price to Book Value
The price-to-book multiple or P/B ratio measures the stock price relative to stockholders’ equity or net asset value on a trailing quarter basis.
Focus on the stocks of companies with sound fundamentals selling at a P/B ratio of fewer than two times. However, finding attractive book multiples at quality companies is rare in a secular bull market. Look for P/B values below the industry and sector median averages during those times.
Some investors prefer a measurement of the tangible book, whereas intangible items such as patents, intellectual property, and goodwill are absent from the denominator. Although accounting for intangible assets is more often an exercise in allowable balance sheet bloat, remember to confirm that management limits permissible manipulation of the entries and is consistent from quarter to quarter.
Price to Forecasted Earnings
Despite my perpetual skepticism of stock market forecasting and the frustration it elicits, the forward price-to-earnings multiple or P/FE ratio is worth a peek when looking to tip the balance on the well-researched stock of a quality enterprise.
The price-to-forward earnings ratio is a valuation method that compares a company’s current share price to its estimated future EPS.
Remember, as a future indicator, placing a heavier weight on P/FE risks venturing into a speculative, roll-of-the-dice crapshoot. So, quality-driven value investors might limit P/FE to a tiebreaker instead of a tiemaker.
Price to Earnings Growth
The price-to-earnings-growth multiple, or PEG ratio, is the P/E divided by the consensus longer-term EPS growth rate forecast provided by brokerage firm analysts based on guidance from the covered company’s senior executives.
The PEG ratio has emerged as a favorite among the growth and momentum crowds. On the contrary, like P/FE, quality-driven investors remain cautious based on the forward projection formula of PEG instead of actual trailing results in a review of the company’s current wealth and the stock price’s present value.
Nevertheless, PEG sometimes provides a substantive peek into a stock’s priceworthiness. Target a PEG ratio of fewer than two times in general or at least below the industry and sector median averages.
Although popular on Wall Street, where most professional investors underperform the broader market, quality-driven investors on Main Street often view discounted free cash flow analysis skeptically because it assumes future earnings, cash flows, inflation, and interest rates. If we try guessing tomorrow’s economics, we are playing the fool’s game of predicting exact future stock prices.
Stick with the facts by limiting research to the company’s current wealth and the share price’s present value.
Buy Quality When No One Likes It
The best time to buy slices of high-quality enterprises is when other investors flee the stock based on near-term negative news or events.
In other words, embrace the upside potential of market corrections and stock price capitulation. Leverage courage, as history has repeatedly shown that bull markets prevail over bear markets in the longer term.
Regardless of the valuation multiples or methods investors employ, remember that quality at value matters in every area of our financial lives, including the stock market. The price paid for value gained endures through each market cycle for decades and perhaps forever.
Own slices of companies with high-quality business models purchased when their stock prices are deemed reasonable or trading at temporary bargain prices after being shunned by the near-sighted crowd.
Frustrating as it may be, owned equities held in a portfolio or targeted common shares on a watchlist often appear at fair value or overvalued to investors focused on accumulating the mispriced stocks of quality companies over long-term holding periods. So practice rational thought, discipline, and patience to keep sifting for value regularly, as the occasional surprise bargain often appears when least expected.
Follow the glorified quarterly Wall Street game of hit or miss solely to discover temporary valuation opportunities in the stocks of quality companies. Nonetheless, is it sinful to wish for a market correction?
Conscientious investors never hope for macro or microeconomic events negatively affecting jobs and portfolios. Ultimately, when one occurs, any available dry powder gets allocated to the discounted stock prices of quality companies that often ensue. One cannot change history, only one’s reaction to it.
Subscribe to the basic tenet of quality-driven value investors’ search for alpha by focusing on a stock’s attractiveness based on valuation metrics relative to the business’s underlying fundamentals.
Finding quality operators in any market is challenging. Uncovering such companies at bargain prices in a bull market is the equivalent of finding the proverbial needle in a haystack. Of course, the haystack is always available to passive investors who buy it with an index fund, averaging to the market, for better or worse.
Price is what we pay for ownership slices of high-quality businesses. Value is what we gain over time from purchasing stocks only when available at a reasonable discount.
Price and value are paramount to matching or exceeding the stock market’s historical average annualized returns from those occasional market pops of big gain days or quarters that underwrite the positive long-term total returns from capital invested and income earned.
Of course, there are intermittent bad days or weeks when investing in stocks. However, the long-term annualized gains suggest the good days far outnumber the bad ones.
We increase our propensity to achieve portfolio alpha by picking the winning stocks of enduring enterprises.
Copyright 2024 by David J. Waldron. All rights reserved worldwide.
About the Author
David J. Waldron is the contributing editor of Quality Value Investing and author of the international-selling book Build Wealth with Common Stocks: Market-Beating Strategies for the Individual Investor. David’s mission is to inspire the achievement of his readers’ financial goals and dreams. His work has been featured on Seeking Alpha, TalkMarkets, ValueWalk, MSN Money, Yahoo Finance, QAV (Australia’s #1 Value Investing Podcast), Money Life with Chuck Jaffe, LifeBlood with George Grombacher, The Acquirer’s Multiple, Capital Employed, Amazon, Barnes & Noble, Apple Books, the BookLife Prize, and Publisher’s Weekly. David previously enjoyed a 25-year career as a postsecondary education executive. He received a Bachelor of Science in business studies as a Garden State Scholar at Stockton University and completed The Practice of Management Program at Brown University.
Resources
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