Investing's Big Secret: Know Your Relatives

I'll admit it: It's not always easy to meet a regular schedule of deadlines. That's not a complaint; it's just a fact. The truth is that I love what I do: I get paid to cover investing topics that I consider to be important.

Usually, that has me hunting and pecking my way through a flood of company press releases, headlines du jour at Google News, and the delightful feature stories at News.com. Not tonight. Tonight, I'm on an airplane, flying home from a brief trip to Canada, joyfully disconnected from the Web. And that's given me some time to contemplate some of the great things I've read and heard from superior investors over the past year. Here's one of my favorites: All valuation is relative.

Know your relatives
Specific credit for this thesis comes from Professor Aswath Damodaran, whom I had the pleasure of hearing speak earlier this year at Fool HQ. He covered the topic with considerable skill, but I won't go into all of the details of this wonderfully rich realm here. (You can find more on your own by visiting the professor's highly instructive website.) I'll focus instead on a question he asked that day, because it resonates above everything else I heard: Why, Professor Damodaran asked, should we blindly compare companies by industry when or if a comparable doesn't exist?

Talk about the lights going on. What a simple statement, and how often ignored. In essence, Damodaran is saying that it's impossible to perform an accurate valuation without first knowing the proper benchmarks. Or, put differently, how do you know a P/E ratio of 12 is good, or of 35 is bad? Neither may be. It's all relative.

iPodsand peas
Allow me to explain with an example. Yahoo! Finance makes it possible to quickly compare any public company with three or four competitors and its industry. Though it appears so, this tool isn't very useful, for it often compares companies of vastly different sizes and growth rates. Let's take an extreme case, such as Apple Computer (Nasdaq: AAPL  ) . Have a look at whom Yahoo! lists as competitors and some of the more important metrics for each:

Metric

Apple

Dell
(Nasdaq: DELL  )

Hewlett-Packard
(NYSE: HPQ  )

Microsoft
(Nasdaq: MSFT  )

Market cap

$54.61 billion

$72.14 billion

$84.69 billion

$298.26 billion

TTM sales

$13.93 billion

$54.18 billion

$86.7 billion

$40.34 billion

TTM net income

$1.34 billion

$3.3 billion*

$3.2 billion*

$12.87 billion

Gross margin

29.02%

17.97%

23.4%

85.0%

Operating margin

11.84%

8.11%

5.7%

42.2%

TTM earnings growth

383.69%

6.59%*

15.3%*

59.2%

Trailing P/E ratio

42.24

21.64*

26.13*

23.67

Forward P/E ratio

31.34

16.9

14.14

18.43

* Excludes restructuring charges and other one-time items.

Do you see how ludicrous this is? I mean, really, comparing Apple and Microsoft on any basis -- even though both vie for dominance in the personal computing and digital music markets -- is like comparing pineapples to peas. It's silly.

If you really wanted to know whether you're paying a premium for Apple's growth and earnings power, wouldn't it be better to find stocks with similar market caps, growth rates, financial characteristics, or cash flow as a reference point? Absolutely, so long as you recognize it as one of many needed reference points for developing a valuation thesis. Does that make sense? Good. Let's get started. My search for the more important characteristics of growth and earnings power at Fidelity revealed four companies. Here's what stood out:

Metric

Apple

Yahoo!
(Nasdaq: YHOO  )

Market cap

$54.61 billion

$59.73 billion

TTM sales

$13.93 billion

$4.83 billion

TTM net income

$1.34 billion

$890.61 million*

Gross margin

29.02%

61.8%

Operating margin

11.84%

20.97%

TTM earnings growth

383.69%

46.78%*

Trailing P/E ratio

42.24

67.31*

Forward P/E ratio

31.34

56.13

* Yahoo!'s net income excludes earnings from investment gains; growth in net income came in at 193% before those gains.

Don't just buy: Compare!
Clearly, there's more art than science on display in this exercise, but the point remains: Valuation is relative. Yeah, I know it's commonplace to juxtapose companies of similar size and industry. That's still a good approach. It just may not always be accurate. (And in fairness, make sure to look for telling signs on industry dynamics and associated growth, capital structure, and stability of growth when comparing outside an industry, since this sometimes may account for differences in P/Es. After all, not everything is static across industries, and the market recognizes this.) Take Dell and Apple, for example. They have very similar businesses, but not exactly. Yet one is the heavyweight in digitized personal entertainment, which, in turn, has led to astounding growth. Which, in turn, has led to a premium-priced stock.

Put differently: Apple's organic growth far outstrips Dell's. And since a P/E ratio is nothing more than a market price for future growth -- and since all of the available evidence suggests that Apple is going to sustain heady growth for a while -- one might say it deserves a gilded price tag. But is the premium fair, or outrageous? How would you know? The only way to find out is to compare Apple with similarly sized companies. Yahoo! qualifies on the surface, but not after a little digging. Excluding gains from the sale of its Google (Nasdaq: GOOG  ) shares reduced Yahoo!'s earnings growth from a world-beating 193% year over year to a more modest but still impressive 47%. Interestingly, the other three candidates found by Fidelity -- British American Tobacco, Brazilian mining company CompanhiaVale do Rio Doce, and telephony laggard LM Ericsson (Nasdaq: ERICY  ) -- experienced too many one-time events to be effective in a comparison.

Thank you, Professor Damodaran
So, maybe Apple really is that good. And maybe it deserves the premium at which it trades. It certainly looks cheap compared with Yahoo! But even that assumes that Apple's iPod franchise will continue to deliver triple-digit income growth. And that's by no means assured.

No doubt, most of you didn't need me to tell you that. It was probably just obvious. What couldn't have been is what the market considers to be a fair price for the kind of growth and earnings power Apple is offering at the moment. Doing this exercise -- inspired by Damodaran's guiding hand and completed in about an hour -- has given us some clues. And that's really what is most important. After all, you'd never buy a car without understanding its value relative to other, similar models, would you? Why, then, treat stocks differently? You shouldn't.

Investment performance is relative, too. Fortunately, every one of our investing newsletters is beating the market handily. Whatever your taste -- wallflowerish small caps to swashbuckling Rule Breakers -- we've got something that'll fit your portfolio. Take a risk-free 30-day trial today. Dell is a Motley Fool Stock Advisor selection; Microsoft is an Inside Value pick.

Fool contributor Tim Beyers is fortunate to have a number of wonderful relatives. He does not own stock in any of the companies mentioned here. You can find out what's in Tim's portfolio by checking his Fool profile. The Motley Fool has an ironclad disclosure policy.


Read/Post Comments (0) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

DocumentId: 500033, ~/Articles/ArticleHandler.aspx, 4/20/2014 2:53:33 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement