Don't worry; I'm not going to leave you with a cliffhanger and make you wait until the end of the article to figure out what you shouldn't be doing. How can you guarantee investing disappointment? Overpay for your stocks.
The math is very simple here. Given a company with fixed future potential, the higher the price you pay, the lower your returns will be. Pay a price that's high enough, and even a great company can limp along with flat returns. Pay a price even higher than that, and you could be setting yourself up for big losses.
As part of my "Back to the Basics" series, I've been breaking down the four key ingredients for stock returns -- earnings growth, valuation, dividends, and share count. Last week I looked at strategies for figuring out growth, which logically brings us to valuation this week.
Hand me that club
Let's head to the golf links for a moment. You're about to line up a shot. What club do you use?
It's a silly question because it depends, right? Distance to the pin, lie of the ball, weather, course conditions, how you're playing that particular day, and a host of other factors could be taken into account when reaching into your bag. And the right club for you may not be the right club for someone else.
And so it goes for valuations. Life as a stock picker would be much easier if there were a pat "right" valuation multiple for stocks. But there's no single, fixed, right multiple for a given stock, let alone stocks in general.
So if that's the case, how can you make sure you're not overpaying for a stock?
Find your range
As I urged with estimating earnings growth, your best bet is to come up with a range of values rather than trying to sharp-shoot a single value. Not only does using a range help you avoid locking yourself into false precision, but it also lets you explicitly see what kind of returns you can expect under varying scenarios.
Even if we're using a range, we need a starting point. But before we go to specific places to look for that starting point, here are some interesting numbers to consider.
- A moving target -- Among stocks that are profitable today and were also profitable three years ago, only 16% had an earnings multiple today that is within 10% -- in either direction -- of the multiple it had three years ago. From 2002 to 2005, it was 19%, and from 2006 to 2009 it was 9%. This tells us that there's a pretty good chance that the earnings multiple for a given stock today will be significantly different three to five years from now.
- Flip a coin -- On an overall basis, it's tough to predict which way a stock's multiple will go. Over the past three years, multiples on 53% of the group referenced above went up, while 47% went down. From 2002 to 2005, it was even more pronounced with almost exactly 50% up and 50% down. Notably, though, this doesn't always hold. From 2006 to 2009, 16% of multiples went up, while 84% dropped.
- Beat the coin -- Though all stocks as a group may be pretty unpredictable, when you look closer it's less of a mystery. Over the past three years, 66% of stocks with a starting multiple below 20 saw their multiple expand, while 67% of stocks with a starting multiple above 20 saw their multiples drop. For the three years ending in 2005, 78% of the lower-multiple stocks saw their valuations increase, while 74% of the higher-multiple stocks saw their valuations decrease.
So now that we have all of that framing the situation, here are a few starting points for setting your valuation range.
- Today's multiple -- Now that I've told you that it's unlikely the multiple will stay the same, am I really going to say that today's multiple is a good starting point? Yes. Remember, it's a starting point, and we're looking to create a range.
- Historical multiples -- Historical performance isn't always a good guide to future performance, but looking at a stock's historical trading range can give us an idea for bounds of our range.
- Growth -- Particularly when it comes to growth stocks, the company's earnings growth rate is often used as a guide for how high of a multiple the stock should fetch.
- Comparable companies -- The stocks of similar companies may trade at higher or lower multiples for good reason. However, looking at the range that competitors and other comparable companies trade in can also help us create our range.
Putting it into action
Let's take a quick look at Transocean (NYSE: RIG ) to see how this might work. Though the company has been under a cloud from the Gulf oil spill and the spill's aftereffects, it's still a major force in the oil and gas industry as the largest offshore driller in the world.
Currently, the stock trades at 14.7 times the company's adjusted trailing earnings and 13 times projected forward earnings. From 2005 to 2010, the stock has had a wide trading range, with an average annual multiple as high as 46.2 and as low as 6.1.
Right now, many other drillers and oil services companies fetch premium valuations as compared to Transocean. On the basis of forward earnings projections, National Oilwell Varco (NYSE: NOV ) , Baker Hughes (NYSE: BHI ) , Weatherford (NYSE: WFT ) , and Noble (NYSE: NE ) all carry multiples at or above 19. Pride International and Ensco (NYSE: ESV ) , which are set to merge, both trade right around 15 times earnings, while Diamond Offshore (NYSE: DO ) has a multiple of 12.7.
Analysts currently expect that the company will grow 12.5% per year over the next five years, and if we use the PEG rule of thumb, then we could say that the stock should fetch a multiple of 12.5.
So where would I set the valuation range for Transocean? Based on the information above, I think we could set a floor around 12, a ceiling of 19, and a midpoint near the current adjusted trailing multiple of 15.
Give it a shot
Now it's your turn. Take one (or a few!) of the stocks you've identified as investment candidates and try creating a future valuation range for them.
Of course if you have questions, thoughts, or rants about what I've reviewed above, feel free to head down to the comments section and sound off. And if you'd like to catch up on the "Back to the Basics" series, you can do that, too:
- What Is a Stock?
- Why Buy Stocks?
- Finding Great Stock Ideas
- Screening for Stocks
- Estimating a Company's Growth
If you're just getting started with investing, let us help you take the first step. Take a look at 13 Steps to Investing Foolishly to find out what it takes to be a great investor.