The path of "value investing" makes it possible for "regular" investors to achieve a return that is better than index. Still, determining the fair value of a stock or its underlying business is never an easy task. Here are several approaches for evaluating a stock:
I. By Earnings.
P/E ratio is probably the most commonly used criteria. On the surface, it makes perfect sense for evaluating a business. However, the earning reported in accounting statement is almost never the true "earning" in a theoretical sense.
First, earnings didn’t count the capital reinvestment that is required to sustain the business at the same level. Some business require a lot of re-investment to stay in business (even without growth). This mandatory reinvestment is taken out from the earning and never meant to be a true "profit".
Second, earning is after deduction of depreciation and one-time charges. Depreciation is never meant to be accurate. Some depreciation on real estate is misleading since the value on many real estate properties actually goes up in general. There are all kinds of one-time charge (non-recurring charges), some are meant be really special and one-time only, and others are actually "recurring" "non-recurring" charges.
Third, Companies usually find all kinds of accounting tricks to make earning numbers look better. Making it hard to analyze until you really dive into the details.
Fourth, in theory, the earnings are profit, but for whom! Too often, the management of the company makes selfish and/or stupid decisions to use these profit in a way that destroys value. Dividend is at very low percentage nowadays, if not zero. The accumulated surplus is then used for stock buybacks or acquistion. It is claimed that this is shareholder friendly because dividend has to be taxed, but stock buybacks are more tax efficient. However, too often the buybacks are conducted at a price well above the fair value of the business. No matter what the buyback price is, the benefits goes to the management who usually holds largest amount of stock option which has a value closely tied to the stock price instead of dividend. "Acquisition" is another commonly abused way to spend shareholder’s profit. The price for "acquisition" is usually higher than what the business is truly worth, and many times the integration is poorly done. In the end, by expanding the corporate empire, the management secures a larger pay and essentially gains more power at shareholder’s expense.
Last, earnings fluctuate widely from year to year. Because of industry cycles and economy cycles, the earning numbers are quite different. The best thing to overcome that is to do an average of past 10 years’ average earning ratio relative to sales. This gives a rough guideline for stable business like Coca Cola, but not really very useful for business that changes dramatically like young companies in high tech industries.
II. By Cash flow.
By using cash flow instead of earnings, the first 3 drawbacks for using earnings are avoided. It may take some research to truly determine the capital reinvestment needed for sustain a business at current level, but for experts, this maybe not too tough to do. It still doesn’t answer the last two questions though.
III. By Price/Book ratio.
This seems better than P/E since book value doesn’t fluctuate too widely during cycles, and it seems to represent the "invested" value of the business. However, the book value may contain a large amount of good will or other intangibles. Even tangible asset can’t sell at the same price it is listed in the book. Inventories may be worth only half of the book value, and the fixed asset such as equipment and factory buildings may worth much less than listed value. Even the fairly liquidable asset may be sold at a tiny fraction of its true value in a fire sale (like Lehman Brother’s building was sold at 20% of the true value).
In another word, if book value is used to estimate the value of business, it must be calculated in detail and computed conservatively. Even in that case, if the business is not liquidated right away and it is surffering loss every month, the loss may be so large to eat up all the differences between book value and market price.
Price/Book ratio is more of a defensive judgement, since it is judged on liquidation basis, not on a on-going business profit and growth basis. This formula is usually suitable for special situations (like bankcruptcy) or form a defensive bottom line. Many great businesses don’t have much tangible book value at all, since the nature of the business doesn’t require much capital input to generate earnings, such as Coca Cola.
IV. By Price/Sales ratio.
Sales number doesn’t fluctuate as much as earnings do. It does have a implied assumption of the profit margin. If in a industry where the profit margin is generally low, it certainly will require a more conservative analysis. It is also better suitable for non-cyclic industries since cyclic industry has large swings of sales number too.
V. By dividend + growth + share number decrease rate
In theory, this is the ultimate formula for determining the value of a business, since the ultimate rate is the dividend rate + average growth rate over time, assuming there is no dilution on shares. However, "growth" is probably the hardest to estimate.
First, Growth in the future is always unknown. We get a series of growth numbers in the past, but it is often a mistake to interpolate and project a future growth number from the past. If we must project the growth rate, it has to be done in a very conservative fashion, just to not surprise ourselves in a bad way.
Second, the growth numbers in the past may be coming from more investment. It is crucial to pay attention to the total number of shares outstanding over the past years. If the company is buying back stocks and reduced the number of shares, it should be added as a investment return. On the other hand, if the company is issuing new shares to dilute existing share holders, it should be discounted as the growth is coming from more external investment.
Third, it is crucial to analyze the quality and characteristics of the growth. Some growth may be an industry-wide pattern for fast growing industries. This kind of growth is usually not sustainable since the product in the industry will sooner or later saturate the market (like cell phone maker). Also, a better return in such industry will invite more capital input and new competitors who will make it tougher to conduct the same business. Some growth is coming from management’s ability or corporate culture. This kind of growth is generally "good" and "reliable" growth, but attention has to be paid on the management changes. The best growth is probably coming from a sustainable competitive advantage or unique business model since this kind of strength can last many decades sometimes and not depend on a single good CEO. When we speak of "unique" business model, we have to understand why it is unique and why it is not copyable by others.
Conclusion: as we can see, it is never a simple or easy task to evaluate a business. A lot of uncertainty lies ahead for the business to change and all the numbers to change dramatically. The best way is to not rely on a single quantitative criteria, but instead, we need to use all of them and aware of their limitations. Qualitative criteria must be used as well, such as management ability and stewardship, durable competitive advantages, leverage and liability of the company, as well as the industry outlook.
Other than conquering emotions such as the impatience, fear and greed, doing hard work and due diligence to do thothough study on the business fundamentals, investment’s primary task is to find the certainties within a world that is full of uncertainties. That task requires constant re-evaluation of the business characteristics and making conservative estimates (including some margin of safety). In average, this prudence and alert to new development will not only find certainties in investment, but also react to real business changes much faster than wall street does, if the surprise does happen sometimes.