Editor's note: This investing classic from a former Fool was published on June 24, 1999 -- less than a year before the greatest bull market in history began to unravel.
As the U.S. bull market inches closer to the two decade mark, many people have de-emphasized valuation criteria from their investment strategies. The reason is quite simple: Over the past few years, taking valuation consideration into account has often not only kept people out of the best-performing stocks, but also left them with companies that have achieved seemingly meager returns.
Someone using traditional valuation tools like the price-to-earnings (P/E) or price-to-earnings-to-growth (PEG) ratios to evaluate stocks would have avoided market stalwarts stocks like Dell Computer (NASDAQ:DELL), Cisco Systems (NASDAQ:CSCO), America Online [now part of Time Warner (NYSE:TWX)], and Charles Schwab (NYSE:SCH). Over the past three years, these stocks have earned compound annual returns ranging from 69% (for Cisco) to 187% (for Dell). Instead of these hot shots, a value player might have purchased "old world" firms like Philip Morris [now Altria (NYSE:MO)] or Minnesota Mining & Manufacturing (NYSE:MMM). The compound annual return on these two stocks has been a relatively paltry 11% and 14%, respectively. We won't even talk about the poor saps who put their money in "small-cap" stocks, many of whom are sitting on losses.
Does the success of the high-growth stocks mean that investors should completely ignore value? A person considering valuation would probably have stayed away from Schwab this past January, because it was trading at 66 times earnings for the prior year. That "high valuation" (more than three times those of most other brokerage firms) hasn't stopped the company from rising another roughly 60% since its release of 1998 earnings. The stock is now going for 90 times earnings over the past 12 months. Similar tales can be told of the other high-flying stocks. While earnings for the companies listed above have been rising, their P/E multiple has been rising even faster.
The skinny on P/E
What exactly does a rising P/E mean? Basically, it means that you're paying more for a specified level of earnings. When you invest $100 into a stock trading at a P/E of 20, you are in effect "buying" $5 of earnings. (You can calculate this for any stock by dividing the amount invested by the P/E ratio. In this instance, $100/20 = $5.) Of course, you're not just getting those earnings for one year. You're getting the earnings the company will generate every year in the future.
If the company experiences 15% earnings growth, the $5 in the current year will grow to $10.06 in five years. On the other hand, if earnings grow at 30% per year, $5 in earnings will turn into $18.56 five years down the road. That difference shows the major power of growth: In this example, a 15-percentage point difference in earnings growth rates results in 85% higher earnings after just five years. Many people seem to be comfortably assuming that the power of compound earnings will bail them out of today's higher market multiples.
I used a P/E ratio of 20 in the example used above. Let's see what happens if we actually use figures from a company actually trading on the market. As mentioned above, Schwab is at 90 times trailing earnings here in mid-1999. That means an investor is getting $1.11 in earnings for every $100 invested. Assume that earnings grow 25% over the next five years (an ambitious assumption, considering that analysts actually project 22% long-term increases). At the end of that period, the $100 initial investment would represent earnings of $3.39, implying an "earnings yield" of 3.39%.
To put that in comparison, you could put money into a 30-year treasury bond and earn a virtually guaranteed 6.16% on your investment every year starting today. In year one, you would earn 6.16%, not the 1.39% provided by Schwab. Of course, that yield is fixed. Regardless of what happens in the macroeconomic environment, buyers of the bond today are stuck with that 6.16% return. On the other hand, Schwab (and other equity investments) have the potential for growth. For Schwab's earnings yield to surpass the bond's yield, it will have to post eight years of 25% earnings growth (from today's record levels). While that's not impossible, it's a tall order to deliver on. And don't forget that while it hasn't happened much recently, the possibility that business conditions deteriorate and earnings decline exists for any stock.
Get down with DCF
I like figuring out the projected earnings yields at various points in time to get a back-of-the envelope idea of what I'm earning from a company's underlying business operations. If you want to get much better valuation information, you should learn how to construct a discounted free cash flow (DCF) model. An unwieldy mouthful, to be sure, but one that's quite informative if you want to understand what a company might be worth using various sets of assumptions.
A DCF involves projecting how much cash an enterprise will generate every year after paying for all capital expenses. These annual free cash flows are then discounted back to the present at whatever rate you want to earn on your equity investments. If you expect to earn a 15% annual return, you should discount future projected cash flows at 15% per year. If you're satisfied with a 10% return, that should be your discount rate. These models can be fairly time-intensive to create, but they could be worth the effort if you're a die-hard investor who likes numbers. A simplified DCF calculator is also available on the Motley Fool Inside Value website.
Stay grounded during boom times
I'm in the middle of reading Tom Wolfe's latest book, the slow-starting, but ultimately engaging A Man in Full. A major portion of the plot deals with an Atlanta real estate mogul, Charlie Croker, who is on the verge of bankruptcy because of the failure of Croker Concourse, a huge development built in the heyday of speculative office buildings. Prior to construction, Charlie's lender enjoyed the "coup" of getting the $175 million loan for the prominent project. After all, with booming real estate rates and sales prices, how could the deal fail? Such an important, seemingly "no-brainer," piece of business was expected to ensure that the bank would remain a great Atlanta institution.
After Charlie defaulted on the loan, the bank was in a much different position. At the point where I had to put the book down to get some sleep, Ray Peepgass, a bank officer, envisions the bank selling the property for $50 million, resulting in at least a $125 million loss on the building. Peepgass commented, "Banks get caught up in the boom mentality, too." If news leaked out of the how lax the bank's underwriting standards became during the good times, he feared "it would become perfectly obvious that we were fools."
Don't let yourself get so caught up in a stock market boom mentality that you overlook the underlying business fundamentals of the companies in which you invest. Otherwise, you might look like a fool rather than a Fool at a later date.
Related links:
- Foolish Fundamentals: Free Cash Flow
- Value or Value Trap?
- Kiss Price-Based Ratios Goodbye
- Discounted Cash Flow Analysis
Interested in valuation and value? Take Motley Fool Inside Value for a 30-day free trial.
Time Warner, Charles Schwab, and Dell are Motley Fool Stock Advisor picks. Dell is also a Motley Fool Inside Value pick.
Warren Gump is the former TMF Gump. At time of original publication, he did not own any companies mentioned in this article. The Fool has an ironclad disclosure policy.
