Video Length – 01:03:51

In today’s session, my co-host Andrew Sather of einvestingforbeginners.com are going to talk about stock valuation methods. Andrew has a great eBook that he wrote a while back that talks a lot about how to value a stock.

Andrew: There are a lot of different ways you can evaluate a stock, there are a lot of different models. I want to talk about some of the simplest ones that you’ll approach, you can always take the subject a bit further. You can talk to experts, they like to talk about things like EV or EV/EBITDA that is enterprise value to earnings before interest, taxes, depreciation and amortization. You could do a discounted cash flow valuation you can do free cash flow valuations.

There are all these different metrics that someone can use to really value a stock. Some of the most basic ones I actually use. We are going to talk about 7 of them and they’re all part of the seven steps that I wrote about in my eBook. IT is also the same 7 metrics I use for my value trap indicator system. All of these combined are what I use to formulate my approach and it’s the exact same method I use to buy every single stock that I buy.

Now, keep in mind you certainly can use one of these. Some people do, you have the Peter Lynch approach where people just strictly look at a PEG ratio, which can be a combination of two of them that we are going to talk about today. You certainly could use just one, there is the Ben Graham approach, which early one was one that Warren Buffett used which he calls the “net, net” approach. Kind of like, the metaphor they use is picking “cigar butts.”

And they really use a price-to-book, more focused on net tangible assets. This is another variation of a valuation method that we are going to talk about today. My whole point is that you could center on any one of these valuations, I argue that when you value a stock, you don’t want a laser focus on making one ratio that much more important than the others. I think you want to take a complete picture approach, understand that there are three financial statements that every single stock needs to post to the SEC.

The SEC puts it on their website and it’s freely available information to us. A lot of investors will look at one little tiny sliver of the financial statements, completely ignore the other ones and get blindsided when they don’t account for things they aren’t looking for.

We are going to look at the whole picture, all seven of these and not so much that they are all excellent but they are all good enough to where you can feel comfortable that number one we are getting a stock at a good price. And number two, that were are getting a stock that has a great business model, and is likely to continue and gives us gains in the future.  

The first method valuation method I want to talk about is probably the most common and every single novice investor knows of this ratio. And that is the Price to Earnings ratio or P/E. What this is going to tell us is, if you think about what a business does, the business will basically spend money and they are going to try to make more than they spend, and that difference is a profit.

And profit really becomes the number one goal of the business, which is something that gets lost in the wash.  A lot of people focus on other things, but really at the end of the day, the goal of a business is to turn a profit. Price to earnings ratio helps ensures us that as investors we are getting a fair share of the profits.

If you take a simple example of Shark Tank, which I love to talk about. Let’s say a business owner out there, they produce custom water bottles that are now this new technology and it’s a rage in the fitness community. Just from what you just heard it sounds like a great investment, it’s a trendy industry and everybody’s trying to expand, and all the customers are trying to lose weight. They have an innovative technology and you have a head start on everybody else but if you are really going to invest money and your friend comes over and says “he, Bob over here is selling his water bottle business, while don’t we split the money and buy it together.   

The first question you are going to want to ask is how much money is he making? Because a guy can have water bottles and it costs $20 to make a water bottle and he only sells them for $25, you are looking at only a $5 profit Sure he could maybe sell enough which would be a good sign of a business model, but if he is only selling a 100 of them a day and you are trying to buy a business for thousands of dollars, and now it doesn’t make a lot of sense.

What it comes down to, how much is Bob going to sell the business to us for and how many earnings are we going to get out of it? Dave, if you and I were going to Bob to buy the water bottle business, and he is selling the business for $100 and he is making $20 of profit per year. Since I am splitting with Dave I am going to be putting in $20 a year and I will get back $10 every year. So in five years, I am going to make my money back, if the company is able to grow, or expand and make more factories like the one behinds us. With the money we get from the business we can spend it on marketing, get more exposure to the business and sell more units. Then I could get my money back sooner.

Now, if he was selling the same business to us and instead of a $100 he wanted $10,000 now all of sudden even though the profits might be great, that is such an expensive price for us to pay that it just doesn’t make any sense for us to buy the business. Because even if the business doubles and is able to make twice and sell twice as many water bottles as before. It’s still going to take years, maybe decades for us to get our initial investment back. 

When you relate what the price of a business is to how much profit is making in the simplest fashion that is what a PE ratio is. The reason why is a ratio is that it all comes down to the numbers. A business that makes twenty dollars a year and a business that makes $20,000 a year just because the scale is different doesn’t mean necessarily that one is better than the other. You always want to compare it to how much you are paying. Because you are comparing it, that gives you a better sense of how much of a deal you are getting. On the most basic calculation, where you are doing price divided by earnings and that will give you the price to earnings ratio, the PE ratio.

There are three other price based ratios that we are going to talk about today. All four of them, including this PE ratio, are all calculated in the same way. It is a simple mathematical equation, we’re taking a price on the top, and we’re comparing it to one of the metrics that we can tangibly look at. And we are just comparing it to see if it is a lower ratio, which is more favorable for us.

In our water bottle example, if we are paying $100 and it’s making $20 in profit, you take $100 and divide it by $20 and we have a PE of 5. If Bob has stars in his eyes and licking his lips at the next Lamborghini that he wants to buy and he doesn’t think that we are smart investors and he thinks that he can take us for a ride. He’s maybe going to try to sell the business at $10000 and if it is still only making $20, suddenly instead of a PE of 5, we have a PE of 500. So that is the difference, a PE of 5 versus a PE of 500. the PE of 5 is lower and it’s likely a better deal for us because we are paying less of a price compared to what the earnings are. In the stock market, you generally want a lower price to earnings ratio, generally as low as you can get it.  

Dave: Exactly, the interesting thing about the PE ratio is value investors love the PE ratio. It is a nice, easy, quick and dirty way of getting a general view of whether the stock is priced accurately or not. By that I mean, generally the lower the ratio is the cheaper the stock is and the more we can look at buying it. Anything, in the 20 to 25 range is acceptable, once it starts getting above 30 to 35 and 40 then it is becoming way too expensive. We talked about Amazon last week, and its PE ratio is I believe 139, so it’s just astronomical. I believe Microsoft’s is 65 right now, these are two huge, very well known companies but their price that people are paying versus their earnings, you are paying a premium for those earnings, that is where people can get in trouble with some of these stocks. This is why this ratio is important, it’s not the end all, be all that some people can make it out to be. It’s a great starting point, Andrew earlier mentioned, which I really liked, that these metrics are a great overview to give you an idea of the financial health of the company, and to see where it is. And also to help identify warning signs that may indicate that maybe this is a company to be wary of. It may be something you like and want to keep on your list, but you may buy it down the road but right now it is just too rich for my blood. You go to the BMW dealership and you see a car you really like but you pass on it because it is simply too expensive right now. You wait until you can find a used one or maybe you buy next year’s model.

The other thing I wanted to mention about the PE ratio, there are a lot of different ways to calculate it and we are not going to go into to those today, but the PE ratio of the S&P 500 right now is I believe around 25 or so, which is really, really high. The average is around 17, so it’s higher than it normally is. You hear a lot of talking heads on the news about the stock market keep going up and up. And yes, it does and so does the PE ratio because people are paying more for the earnings that are being produced. They are paying more for the profits that a particular company is generating. As it gets higher and higher you start to get into stock market areas where it could crash or have a big drawdown. And those are times where we can jump in and buy things as value investors because we are looking for deals on companies.  

This is another area that the PE can come into play, is that it can help us see when things are overvalued for a really good company and when there is a correction in that price, then we can take advantage of that. For me, that is where a PE ratio can really come in handy. 

Andrew: Yeah, I have seen some success with just the PE ratio when I just started out. I think this was a company that you might have talked about before, Corning (GLW). I remember they were one of the first stocks I ever bought, I also bought Microsoft (MSFT) as my first. I bought Corning, that was my first Benjamin Graham stock and it was very undervalued for quite some time. I don’t remember what the exact PE ratio for it was but I do believe it was under a 15 when I bought it. the PE ratio stayed low for a while, and even today it is below 20. When I bought it, one of the criticisms of this stock was that it had been flat for a very long time, it was flat for two or three years. But being confident in this Graham philosophy I went ahead and bought it. And within the first year it I think I made 60 or 70% on it and I think at one point it did double.

This is just one small example and there countless more you can screen for. Right now I am on the S&P 500 on my stock screener and sorting through the lowest PEs you have companies like eBay is at a 5 right now, General Motors and Ford are both below 10. Generally, different industries tend to trade at lower pe ratios, which is a whole another topic for a different day. You can even compare a PE to its competitors, you can see one pe lower that another that might be an indicator that one company has an advantage over the other, as far as an investment philosophy goes.