One of the most frustrating aspects of investing is the question of valuation, especially for the less experienced. It seems there are as many theories on determining the proper price for a stock as there are Saddam Hussein doubles.
Many investors sometimes combine stronger elements from the different credible theories out there, whether they're conscious of it or not. Today, I'll talk about just such a method, one that has been around for dozens of years.
Foundations and castles
Of the most popular investing methods, the most respectable and widely accepted is the firm-foundation theory. This theory states that every security has a certain intrinsic value that can be determined through careful analysis of a company's growth rate, dividends, risk, and other factors. A stock's price will fluctuate around this firm anchor and, when it strays too far, it becomes either overvalued or undervalued. This is the foundation for legendary value investors like Benjamin Graham and Warren Buffett.
And there's no question about a stock's price being tied to its perceived intrinsic value; a 1982 study by Burton Malkiel and John Cragg established a definite relationship between a company's estimated growth rate and the price-earnings multiple awarded by the market. The higher the anticipated growth rate, the higher the P/E. No surprise there.
"What is important to realize," writes Malkiel, "is that there does seem to be a logic to market valuations."
Another method of valuing stocks employs the castle-in-the-air theory. This is perhaps best described by the famous economist John Maynard Keynes, who wrote in 1936 that, "... professional investors prefer to devote their energies not to estimating intrinsic values, but rather to analyzing how the crowd of investors is likely to behave in the future and how, during periods of optimism, they tend to build their hopes into castles in the air."
The castle builders argue it's extremely difficult to ascertain a stock's firm foundation and, even if one is successful, the foundation is likely to shift anyway. As some have said, Res tantum valet quantum vendi potest: A thing is worth only what someone else will pay for it.
Best of both?
Certainly there are elements of truth in both theories, and it just so happens that the very first book I ever read about investing describes a way to combine them when evaluating stocks.
Stock Market Primer was written in the early 1960s by Claude Rosenberg, Jr. It's a very thorough investing guide, covering everything from P/E ratios to railroad-car loadings to the Intercity Trucks Tonnage Index. The heart of the book is a "compounding growth guide," indicating fair price-earnings multiples for different kinds of stocks under different kinds of conditions.
Rosenberg does a good job of explaining fundamental investing, from choosing the right industry to choosing the right company within an industry to determining a reasonable price for the company's stock. He also says all of the fundamental stuff would work just fine if investors were completely objective when it comes to buying and selling. However, he writes, "Nothing could be further from the truth! Human beings live by their emotions, and it's tough to shut them off suddenly when investing."
These emotions can cause people to pay more -- or less -- for a stock than they normally would. Rosenberg suggests there's a way to compensate for that when you're doing your research: Determine the sex appeal, or glamour, of each company. By classifying them as average, above average, or super glamorous, you can make adjustments to the earnings multiple you're willing to pay.
How do you ascertain which stocks have high glamour appeal? Rosenberg says to look for companies that are recognized leaders in their fields, have experienced long periods of growth, have strong management, and whose names alone indicate strength in the minds of investors. Finally, allow common sense to be the final arbiter. Cigarette makers and landfill operators, for example, will generally struggle in the glamour category (though they may do just fine in the swimsuit competition). Others, like Wal-Mart (NYSE:WMT), Microsoft (NASDAQ:MSFT), and eBay (NASDAQ:EBAY), are oozing with glamour.
With that in mind, then, here's a sample of Rosenberg's compound growth guide:
P/E multiple you should pay for a company with a 20% CAGR:
Avg. Glamour Company -------------------- Bond yields 3.5-5% 8-9% 11-15% ------ ----- ----- 20-25 16-20 10-12 Glamour Company -------------------- Bond yields 3.5-5% 8-9% 11-15% ------ ----- ----- 25-30 21-23 12-14 Super Glamour Company -------------------- Bond yields 3.5-5% 8-9% 11-15% ------ ----- ----- 30-35 24-30 13-15
As you see, the guide combines firm-foundation aspects (anticipated EPS compound annual growth rate and bond yields) with a decidedly castle-in-the-air aspect (glamour) to come up with a fair range of P/E multiples for a stock.
Comparing companies with an anticipated 20% growth rate in a low interest rate environment (like we're now experiencing), we can see that Rosenberg suggested a P/E range of 20-25 for an "average" glamour company. That bumps up to 25-30 for stock with above-average sex appeal, and to 30-35 for one with super glamour.
I can't reprint the entire guide here, but it should be a good exercise for those interested to extrapolate and make their own table.
One caveat: A stock's glamour appeal, like anything else in investing, can change quickly. We need look no further than the examples mentioned in the 1987 edition of the book. One of the super-glamour stocks back then was Xerox (NYSE:XRX), a company that began to fall apart a few years ago under the weight of declining revenues, bad management, and an accounting scandal.
Finally, it's worth considering Rosenberg's comments on Philip Morris, since renamed Altria (NYSE:MO). Then, as now, the company lacked sex appeal. (And the new name isn't helping matters. "Honey, is that coat made from Altria or mink?")
In comparing Flip Mo to Emerson Electric (NYSE:EMR), he noted the latter sold at a higher P/E every year in the 1970s, despite the fact Philip Morris had "vastly superior" profit growth. "The reason: Cigarettes and beer... have far less glamour than the image of electrical equipment."
That condition has largely persisted up to now. Both companies are expected to grow earnings at about a 10% rate over the next few years, yet Altria's P/E has ranged from 6 to 21 the last five years, while Emerson has sold between 14 and 29 times earnings.
Rosenberg sums up his philosophy thusly: "Avoid paying large premiums for glamour, but do not neglect it entirely."
Rex Moore rates himself "exceedingly below average" in the glamour department. He owns shares of Microsoft and eBay, as can be seen on his profile page, as required by The Motley Fool disclosure policy.
