by WWM | Jan 31, 2018 | Investment Analysis
Financial ratios have value to investors and analysts. But there are also limitations to their usefulness.
Why is Dividend Yield Important?
Dividend yield calculations are important to investors in two different areas.
Fixed Income Investing
Some investors seek investments with a steady income flow. They tend to be the more risk averse, fixed income investors.
The dividend yield of a stock allows them to compare the income stream against fixed income alternatives. That may be other companies that issue dividends. Or it may be other asset classes, such as money market or bond investments.
It also lets them review historic and expected dividend payouts to provide some comfort as to future income streams.
Finally, although locking in a (hopefully) fixed income stream, there is also the possibility for capital appreciation should the share price increase. As with bonds, if general interest rates fall, the price of the shares should rise.
For example, consider Prefco. When general interest rates were 4%, the unique circumstances for the company (earnings potential, competitors, industry, risk, etc.) required that they issue their preferred shares at $50, with a fixed dividend of 5%. This equates to an annual payout of $2.50.
If general interest rates decrease to 3%, there will be an impact on the company’s shares. Probably not an identical impact, but some change. Perhaps the appropriate yield for Prefco based on the lower interest rate is 4%.
As it is pays 5% at $50 per share, investors will buy Prefco as a value play. This will drive the share price up, until it hits $62.50. The price reflecting the new appropriate yield of 4% ($2.50 annual cash dividend divided into $62.50 share price).
Investors who bought shares in the original offering will have unrealized capital gains of $12.50 per share or 25%. Nice if you invested solely for the dividend income. Of course, if interest rates rise, investors may experience unrealized losses.
Value Investing
Value investors seeking capital gains also use dividend yield in their quantitative analysis.
The dividends are nice as they provide a hedge should the shares not appreciate. But the main hope for value shareholders is an increase in share price.
Value investors look for companies with relatively high dividend yields. Relative as compared to benchmark yields, including: company’s history, competitor, industry, sector, stock market. Yields would also be compared to interest rates offered on money market instruments and bonds.
The belief is that high dividend yields results in two possible actions.
One, high dividend yield may indicate the share price is undervalued. Over time, the company’s fortunes will improve and the dividend yield will revert to historic lower levels relative to the benchmark employed as the share price increases.
Two, fixed income seekers will identify the high dividend yield stocks as superior investments versus lower yield alternatives. As the fixed income investors increase demand for shares of the high yield company, the share price will rise, bringing capital gains to the value investor.
As the high dividend yield returns to a lower rate, demand slows and the share price finds equilibrium at a reasonable dividend yield. Reasonable being in line with investor demand based on expectations of the company’s future performance, ability to pay dividends, etc.
The Prefco example above illustrates this principle. The same holds true for common stock (and bonds).
Dividend Yield Limitations
The Past is Not the Future
What transpired in the past is no guarantee of future events.
Dividends are only paid if the company has adequate free cash flow to pay shareholders. Company expansion, new debt issues, dealing with lawsuits are all examples of activities that can erode free cash positions.
Just because a company has made payments in the past does not mean that they will continue in the future. This is especially true concerning common shares. Of less concern are preferred shares, but there is still a risk.
Note that companies do not like to slash or cancel dividends if they historically pay them out. Reducing dividends is usually perceived by investors as negative information about a company’s future results.
Investors like dividend consistency. Companies that fluctuate their payouts are less attractive to investors. This necessitates the company having to increase their dividends, when they do pay them, to entice investors to accept a risk of periods with smaller or no dividends.
High Yields Can be a Negative
Companies with high dividend yields are often mature companies with minimal opportunities for continued operational growth. Because of the limited internal investment possibilities, these companies tend to have high dividend payout ratios.
A dividend payout ratio is the amount of dividends paid to shareholders divided by the net earnings of a company. Companies that payout all their earnings in dividends have a 100% payout ratio. Companies that pay no dividends have 0% payout ratios (100% earnings retention ratio).
High payout ratios are good for those seeking dividend income, less so for those who desire capital appreciation.
Consider a low dividend payout company, or one that does not pay any dividends.
Often these companies prefer to reinvest positive cash flow into growing the business. Purchasing new equipment, conducting research and development of new product lines, spending money to market existing products. Expenditures that work to increase revenues and profits. Which, in turn, should drive share price over time.
Investors believe that the return from cash reinvested in the company’s operations is a better investment than receiving a dividend and investing it elsewhere.
As a value investor, you may see limited capital appreciation in a value stock if there are few opportunities for internal growth and the company distributes its retained earnings to shareholders.
High Yield Indicates Value and Junk
As with low Price/Earnings (P/E) or Price/Book (P/B) ratios, high dividend yields may indicate value in a company’s shares.
But it may also indicate that the shares are worth less than previously thought by investors.
An Example of Limitations
On July 1, Junkco traded at $50 per share and had a trailing dividend yield of 4% (so its annual dividend is $2). This yield was considered reasonable as compared to industry and market averages, as well as to prevailing interest rates offered in the bond and money markets.
On July 10, Junkco announced that it lost a key sales contract that provided 85% of its annual revenue. With no replacement sales available, the share price plunged to $20.
Not good for the company, but great for the dividend yield. It rose to 10%. Much higher than benchmark comparisons.
But does this make the company a value play or a good investment?
If Junkco cannot replace the lost 85% of total revenue, earnings and cash flow will suffer. Junkco may survive this much lost revenue in the short term, but over the long run they will need to scale back their operations or face bankruptcy. Without new sources of revenue, Junkco is definitely not a value stock.
The same warning applies to fixed income investors.
If the original 4% yield was considered reasonable, then at 10% Junkco should be very attractive for dividend seekers.
And if Junkco can replace their revenues, it might be a great deal.
But if they cannot, even in the short term, I would expect Junkco to cancel or severely reduce their dividends. If Junkco reduces the dividend from $2 to $0.50, that would lower the dividend yield to 2.5%. Not a good deal versus the old yield of 4%. And if they cancel the dividend due to lack of cash, that would be even worse for fixed income investors.
Final Thoughts
All quantitative analysis – P/E, P/B, and dividend yield – can be a good indicator of a value investment. But they can also lead investors to see poor investments as having value. Never crunch numbers in isolation.
You must also perform qualitative analysis to separate good from bad. To put the numbers into proper context.
Never ignore the soft side of the analysis and only focus on the numbers.
Avoid the free lunches. If something looks too good, there may be a (negative) reason.
by WWM | Jan 24, 2018 | Investment Analysis
Another key ratio used by value investors, as well as by those seeking positive cash flow, is the dividend yield.
Whereas value investors seek companies with relatively low price-to-earnings (P/E) and price-to-book (P/B) ratios, they desire companies with high dividend yields. Lower risk investors like high dividend payers for both the cash flow it generates and the the quicker payback on their invested capital.
What is Dividend Yield?
There are two ways to think about dividend yield.
First, dividend yield is an indicator of how much annual cash flow an investment generates.
If you own an investment that yields 10% per annum, you know how much cash flow you will receive each year. If you invest $100, you will receive $10 each year.
Some investors may need a specific cash flow to fund their lifestyle. Retirees are a good example. Knowing with some certainty what the annual cash payout will be, as opposed to hoping the share price increases, is very useful.
Additionally, when comparing potential investments, understanding the relative cash flow may help determine what to purchase. If the average industry dividend yield is 8% and you identify a company yielding 12%, that may be a nice value investment. Of course, offering a higher than “normal” dividend might also foreshadow future difficulties too.
Second, the dividend yield indicates the payback period on an investment.
That is, how much time is required for repayment of your initial capital. If you invest $1000 in a company with a 10% annual dividend, you will recover your original $1000 in 10 years.
A good analytical tool if you are concerned about the safety of the capital you initially invested.
That said, I would be more concerned about payback period if I was drilling an oil well, buying commercial real estate, or expanding manufacturing facilities as opposed to investing in a stock. But there are some investors who are interested in payback periods via dividends.
Calculating the Dividend Yield
Dividend yield is calculated by taking the amount of dividends paid annually divided by the current share price. Or the price you paid when investing.
Unless the dividend is increased or decreased by the company, the yield will be constant for existing shareholders.
For example, ABC company pays a steady $1 per year dividend. You bought 100 shares at $12 per share. Your sister bought 200 shares at $8 per share and your brother bought 500 shares at $15 per share.
You will receive $100 in dividends annually with a yield of 8.3%. Your sister will receive $200 annually. But because she bought at a lower share price, her dividend yield is 12.5%. And your brother will receive $500 in dividends each year. However, as he bought his shares at $15 each, his dividend yield is only 6.7%.
Some companies may pay dividends in terms of percentage payouts. Do not confuse this with the yield. The dividend yield is based on the price you paid for the shares. The stated percentage dividend is based on the share’s par value at issue.
For example, Fixedco issues A Class Preferred Shares at $100 par value with a fixed 6% annual dividend. For each share you own, you receive 6% of the par value. In this example, $6.
If you purchased the shares at $150 each, you will still receive 6% of the par value, not 6% of your purchase price. You will earn $6 annually and your dividend yield will be 4%.
You may also see bonds that are variable rate or reset based on certain conditions. For example, the 6% fixed rate may be adjusted for inflation every 2 years.
Dividend Yield and Share Price
Assuming a fixed dollar or fixed percentage dividend, investors’ yields will vary dependent on when they purchase the shares. Fixed rate dividends are usually seen in preferred shares.
If investors paid more than the par or issued value for the shares, their yields will be lower than the original fixed yield.
If they paid less than par or issue value, they will receive a higher yield.
We saw this in the examples above. As well, exactly the same principle as with bond yields.
If the dividend paid varies over time, as is the case of most dividend paying common shares, then a shareholder’s dividend yield will also vary. Many companies increase their dividend payouts in good times. In bad periods, some companies will reduce issued dividends. Though, due to the perceived negative message sent to shareholders and potential investors, companies usually try to avoid decreasing payouts.
Given that the cash value of dividends paid out over time may change, as well as the share price will fluctuate, it is usually a good idea to track two yield calculations.
One, the yield based on what you paid for your shares. Two, the yield based on current market value.
For example, you purchase 100 shares at $10 per share. The annual dividend is $1 per share. Your dividend yield is 10%.
A year later, the company increases its dividend to $2 per share. Based on your purchase cost, your yield is now 20%. However, investors are extremely bullish on the stock and the share price has grown to $25. The current yield on the shares is now only 8%. If you purchased another 100 shares at the current price, now your new adjusted cost base will be $17.50 per share. Your new overall dividend yield will be 11.4%.
Analytical Considerations
As with price-to-earnings, investors consider dividend yields based on actual payouts (e.g. previous year, 5 year average, etc.) and on on expected future payouts.
If assessing whether to invest in shares, I suggest comparing the expected future yield against the 5 year average payout to determine any trend of increasing or decreasing the dividend.
I remove any extraordinary or special dividends from my comparative data.
These dividends are paid only on special occasions and are not recurring in nature. Excluding them from the analysis allows for better comparison with normal dividend payments.
I also review the company’s dividend history.
Have prior year dividends been stable or increasing in amount? Or have there been periods when dividends were reduced or not paid? If the former, there is more comfort that future dividend streams will continue. If the latter, the risk of reduced future income rises.
Finally, or perhaps firstly, consider the after-tax ramifications of dividend payouts. Tax laws differ between jurisdictions, but always focus on your net cash flow. Not gross payouts.
For example, in Canada, certain dividends are eligible for tax credits. This increases the net yield versus dividends received from a non-eligible issuer. Or perhaps a foreign issuer withholds tax when paying out dividends. This may or may not be recoverable, but is always worth considering.
Next week we will look a little more deeply as to why dividend yield knowledge is important for investors. We will also review the potential limitations when using dividend yields in your investment analysis.
by WWM | Jan 17, 2018 | Investment Analysis
There are a few problems with using book values to assess company and per share value.
We shall review those, as well as look at how to improve the usefulness of Price/Book (P/B) ratios.
Book Value is Not Liquidation Value
The book value of a company’s net assets may not be the same as upon liquidation.
As a general rule, the closer an asset is to cash, the closer the asset’s book value is to its liquidation value.
For example, cash is cash. Current assets such as trade receivables and inventory are relatively close to cash realization value. But for fixed assets like vehicles, equipment, and real estate, there might be large differences between book and realizable values. The farther out the time to cash realization, the less connected is the book value to market value.
At times this may be a positive, such as when the real estate market is strong and a 20 year old factory is listed at its original purchase price.
Often though, it is a negative.
Perhaps the company owns a fleet of vehicles that it is depreciating straight-line over 5 years with zero residual value. That means that after year one, the vehicles are still valued at 80% of the purchase price (divide price of vehicle by 5 years of straight-line depreciation. End of first year, vehicles will have a book value of 80%. Second year, 60%. Third, 40%, etc.). But if one needs to sell them at the end of year one, it may be difficult to get that high a sales price.
In a depressed real estate market, a forced sale of the company factory may realize significantly less than book value.
You must consider whether book value approximates realizable value. And how much realizable value may differ from an orderly sale (where you can bide your time to receive market value) versus a fire sale.
Book Value is a Balance Sheet Concept
Book values are based on balance sheet values that took place at a single point in time.
In general, that is always a problem with balance sheets. They are simply a snapshot at a specific date. By the time you receive and review a company’s financial statements, up to 6 months may have passed from the balance sheet date. Much may have happened in that period to alter the company’s current financial position.
But what happens when most companies need to liquidate?
Liquidation is usually due to poor operating results that cause losses and negative cash flows. Even if the current balance sheet appears strong, losses and net cash outflows will quickly erode the future book value of a company.
There may be lawsuits from customers, shareholders, governments, or other parties that force the company to ultimately liquidate. Fines, lawyers fees, etc. will also lower book value.
Employees may need termination packages upon liquidation. As a going concern, a company would not account for these costs on its books. But they may need to be paid.
Just because a company’s book value is currently greater than its market capitalization, it does not guarantee anything about the future book value.
As the business deteriorates, so too will its book value. If you invest today, based simply on a P/B less than 1.0, you may find in a year or two, the ratio has increased significantly.
A Company’s Value Should be More than a Sum of its Parts
A company’s value should be based on how it employs its assets and less on the assets themselves.
A company could own a large factory filled with manufacturing equipment. But if it does not produce a product that meets the needs and desires of its customer base, it will have no sales.
Book value does not factor in key management’s value to a company. Warren Buffett is the standard example here. But many companies have key employees who add value to the business.
Same with intangible assets that tend not to be included in book value calculations. Patents, goodwill, etc., do bring actual benefit to the company.
This holds true for competitive advantages, such as being a monopoly or possessing large barriers to entry in a market.
That is why the “whole should be greater than the sum of the parts.” Many things not factored into P/B ratios are important to a company’s success.
When considering companies, look at how they use their scarce resources to strengthen the business. Not simply whether they have resources. And never ignore intangible assets or competitive advantages that may exist.
Low Book Values May Be Deceptive
A low book value is usually seen as a positive to the value investor.
In this age of technology and information, investors tend to have access to the same data and calculations in real time. You most likely are not the only person to recognize a particular stock has a P/B below 1.0.
If other investors identified the low P/B stock as an opportunity, they would begin to purchase shares. Increased demand drives up the share price, thereby adjusting the P/B ratio higher.
As with the price-to-earnings ratio, you need to ask yourself why these other investors are not buying shares in the company. Perhaps because they believe the company is truly worth less than its net assets. Often due to perceived weak future expected performance, a potential for lawsuits, etc., that over time will cause the asset base to deteriorate.
As we saw above, if a company’s net earnings and cash flow cannot pay its ongoing obligations, the company will have to liquidate existing current and fixed assets to pay its debts. This will reduce future book value and make the company much less of a value.
If you identify a low P/B stock and it looks attractive, perhaps you are a shrewd investor. Just realize that there are many other investors out there who saw the same data as you and did not buy.
Adjusted P/B Ratios
While I do not use P/B ratios in my analysis, I do use an adjusted P/B ratio.
First, I start with a company’s net book value as traditionally calculated.
Second, I add back any intangible assets that I believe hold some residual value.
Third, I review the balance sheet and try to adjust any assets to better reflect realizable values.
For example, if a fleet of vehicles is on the books at 80% of their purchase price, I may attempt to assess their proper value if sold on the open market. Usually I consider both a normal sale and any price change should there require a distress selling price. Maybe an ordered sale will provide 60% of the original price and 40% for a distress sale.
In short I am attempting to perform a business valuation on the company to assess its real value, not simply a book value.
Then I use that data in comparison with the company’s market capitalization.
If I am concerned about a company’s potential bankruptcy, I would probably skip it as investment. But if I did attempt to value the business, I would also factor in any costs normally associated with liquidations.
Not a fool-proof method, but infinitely better that using net book value alone.
Note that if you use an adjusted P/B, you must be careful when comparing it against competitors, industry, or market averages. The reason is that the other metrics are not adjusted, so you need to avoid comparing apples to oranges.
Never Forget the Qualitative Analysis
Exactly the same advice as with the price-to-earnings analysis.
Low P/B stocks may indicate value investments.
But they may also indicate junk companies on a short road to bankruptcy.
You must always consider the qualitative side to help separate the good from the bad.
by WWM | Jan 10, 2018 | Investment Analysis
Another common analytical calculation is the price-to-book (P/B) ratio.
Very popular among value investors.
While price-to-earnings considers a company’s future earnings potential as a way to determine share price, P/B incorporates what the company owns.
Not a ratio that I find very useful, but many others do, so you shall not suffer for my biases.
We will cover how to calculate and use P/B ratios, followed by limitations in the ratio’s effectiveness. Then I will show you how to make the P/B ratio a little more practical.
Price-to-Book Ratio
The P/B ratio is used to compare a company’s market capitalization to the book value of its net tangible assets.
Think of it like buying a new car during a slow sales period. According to your research, the car you want has a $40,000 value. You have the choice of two dealers who both sell the model for $40,000. Neither can go below that amount due to price obligations with the manufacturer.
One dealer is firm on the price. The second dealer is more flexible. To get your business, he upgrades the stereo system ($2000 value), adds air conditioning ($1000) and a pair of fuzzy dice for the mirror ($10).
You are spending $40,000 to get a car now “valued” at $43,010. You believe you are getting a deal and purchase it from the second dealer.
Or perhaps due to sudden financial distress and a slow real estate market, a family needs to sell its home quickly at below market value. If you are in the right place at the right time, you may buy at a nice discount.
The same principle holds true for shares. You are trying to buy something for a price less than its worth, as valued by its assets on a per share basis.
If a company’s net assets are worth more than the price of its shares, it may be a value stock. The idea being that as other investors realize the stock is trading below its actual value, they will purchase shares and cause a price increase.
Book Value
Book value, or as I prefer “net book value”, is found by taking total assets on the balance sheet and then subtracting all liabilities and any intangible assets.
Intangible asset are assets that are not tangible (physical) in nature. Intangible assets include: goodwill, patents, trademarks, intellectual property.
Note that while deducting intangible asset book values is normal practice, I do not do so myself. Some intangibles may have actual value – a patent or brand name, for example – that will be worth something in the event of a company sale. What that value is varies from company to company based on its unique situation. But keep in mind that intangibles may have value even if they generally are excluded from net book value calculations.
For value investors, low book values are desirable.
Say a company’s net book value exceeds its market capitalization. If a company distributes its net assets tomorrow, the amount transferred to shareholders will exceed the total value of shares outstanding. A nice safety cushion for shareholders on their invested capital.
Calculating the P/B Ratio
The P/B ratio is found by dividing the share price by the company’s book value per share.
Most free stock quote providers (e.g., Yahoo Finance) offer this analytical information, so no need to calculate.
Some investors use the P/B ratio to assess a fire sale scenario. If the company shut its doors tomorrow, what is the value upon dissolution and distribution of assets to shareholders? Ideally, shareholders would like to have enough net assets to cover their investment value.
Any P/B ratio less than 1.0 indicates that the per share book value of the company is worth more than the share price.
The higher the ratio, the less chance that the company’s net assets can cover the share value.
Value Investors Seek Low P/B Ratios
Investors using value strategies often focus on low P/B ratio companies as one of their criteria.
To continue with the Wells Fargo (WFC) example from our price-to-earnings post. Data is as of January 8, 2018, in US dollars, via Yahoo Finance.
WFC’s current P/B ratio is 1.69. That means that the company’s net book value is worth less than its market capitalization.
For value investors, not something they might seek in a stock as they want share price undervalued to its net assets.
A value investor may be more intrigued by Citigroup with its P/B ratio of 0.96. In theory, if the company liquidated its assets, paid its debts, each investor would be able to receive full share value, with a little extra. Whereas WFC shareholders would only receive, in theory, $0.59 for every $1.00 in share value (invert the 1.69 P/B ratio).
Investors really focussing on P/B in the Financial sector may also be interested in AmTrust Financial Services, Inc. (AFSI) or Barclays PLC (BCS). AFSI has an even lower P/B ratio of 0.77, while BCS has a P/B ratio of 0.53.
Growth Investors Less So
Growth investors are more focussed on a stock’s growth potential as opposed to ensuring their capital is covered. As such, P/B ratios are of much less, or no, importance.
Not to mention that growth stocks often have high P/B ratios. For example, Google (GOOG) currently sits at 4.86. Facebook (FB) at 7.64. Amazon (AMZN) at at very heady 24.45.
Not much coverage of investors’ share capital in most growth stocks.
Does that mean investing in growth stocks is a poor strategy? Not at all. Growth investors simply focus on other analytics to assess potential investments.
In Short
In theory, investors’ capital should be quite secure in event of liquidation for low P/B ratio equities.
But is it?
I use “in theory” a fair bit when discussing P/B ratios.
Yes, knowing a company’s book value and its P/B ratio provides investment information. Always a good thing. But you need to be aware of potential problems associated with book values.
We will look at those next time.
by WWM | Jan 3, 2018 | Investment Analysis
The price-earnings (P/E) ratio is probably the most widespread analytical calculation used by investors.
Yes, it can provide insight into a company’s share price. Note that I say can, not does.
But there are also a few potential problems with P/E ratios.
Garbage In – Garbage Out
Calculations are only as good as the quality of inputs.
If it were easy to estimate future earnings and price-earning multiples, one could accurately chart future share price. Then analysts would be at home getting rich, not crunching numbers all day in a tiny office or cubicle.
There are so many variables that need to be factored into a company’s future earnings that it is impossible to get them all right, or even close to right.
And there are always unforeseen events that take place to complicate things further. Even if your data is pristine and not garbage, you still run the risk of getting it wrong.
On September 10, 2001, I do not imagine many analysts factored in the next day’s terrorist attacks that impacted share prices across the board.
In 2016, how many analysts foresaw the Trump election in the United States? Not that this is directly correlated to the yuugge increase in equities in 2017, but there was some impact. Not to mention all the “experts” who claimed that stocks would tumble if Trump was elected.
In late 2017, tax reform legislation was passed in the United States. Again, this was unforeseen a year prior and will have direct impact on many U.S. based companies. As well, if you follow international news, there is concern in many countries that U.S. based companies may now have competitive advantages over (say) German or Australian firms. This has led to calls of similar corporate tax reform in these jurisdictions to level the playing field.
So many examples out there of how consensus views suddenly had to adjust. In 2018 and beyond, this will also be true.
Both the number of variables and the possibility of unforeseen events occurring makes it very tough to accurately estimate EPS. And the farther away the estimate, the greater the probability of error.
When relying on someone’s estimates, never take them as the absolute truth. Inputs may be good at that moment in time, but may become irrelevant in the near future.
Data is Fluid
The data impacting future earnings is always changing. Similar to my above examples, these occur at the company level.
Each day new information is uncovered that affects a company’s future performance. The departure of a key executive, the announcement of a new contract for sales to China, a lawsuit against the company, a new product, etc.
With each piece of new data, the expected future results will change. As such, both future expected EPS and P/E for a company may be fluid and shift up and down over time.
No One Sees Things the Same
Different analysts may arrive at completely different conclusions, even given the same facts.
For example, consider JPMorgan Chase. A rather large company in the relatively stable finance sector. Not hugely volatile.
Per Yahoo Finance as at January 2, 2018, JPMorgan has 26 analysts estimating its 2018 EPS. The average estimate is USD 7.77. However, the lowest estimate is USD 7.45, while the highest is USD 9.25.
Not a huge variance, but given that all analysts should have access to the same raw data, you would expect a much tighter range. The difference is due to how each analyst interprets each variable.
Even at this level, who is “right” and who is “wrong” can result in different valuations.
As at January 2, JPMorgan traded at USD 107.26 with a 15.46 trailing P/E ratio. If the ratio holds, the consensus opinion is that JPMorgan has a target share price as at December 31, 2018 of USD 120.12. A nice gain of about 12% for 2018.
However, the pessimistic analyst with the USD 7.45 EPS estimate only expects a price of USD 115.18. A gain of only 7.4%. Whereas, the analyst who estimates EPS of USD 9.25 expects a share price of USD 143.00. A gain of 33.3%.
Quite the different outcome for two investment professionals assessing the same raw data.
And that is an established company in a relatively stable industry. If you look at small or new companies, or those in more volatile sectors, you will likely see greater dispersion in estimates.
For example, Facebook (FB). As at January 2, it has 41 analysts predicting 2018 EPS of USD 6.63. At today’s share price of USD 180.21 and trailing P/E ratio of 34.88, that leads to an estimated share price of USD 231.25. For a gain of 28.3%. Much better than the consensus 2018 increase of 12% for JPMorgan.
However, the range in 2018 EPS estimates for FB go from USD 5.73 to 7.45. At the high end, that translates to a share price of USD 259.86 and a gain of 44%. But on the low side, it may mean only a share price of USD 199.86 and a 10.9% increase. At this lower level, JPMorgan might actually be the better (and less risky) investment.
You can see there is quite a range of results depending on how the raw data is interpreted. Who you follow can play a significant role in your investment choices and expectations.
Bitcoin (and other cryptocurrencies) is an extreme example of this. At the end of 2015, Bitcoin traded at USD 429.78. By the end of 2016, it was trading at USD 958.24. A gain of 123%. Nice.
Starting 2017, some saw Bitcoin much like Dutch tulips. Others as the wave of the future. But I am not sure very many estimated Bitcoin trading near USD 15,000 at Christmas. Quite the increase.
This is why investors religiously follow specific analysts who have excellent track records. And why these same analysts earn extremely high compensation.
And yes, I am ignoring the herd mentality effect of analysts. Something that is very real and actually works to keep estimate ranges closer than they should be. A few analysts like taking contrarian views. But the mast majority like to hide safely within the herd.
Sometimes All Stocks Are Down
Even strong companies may fall in price.
In a bear (down) market, many stocks appear undervalued. But until the market, as a whole, improves and investors start to invest in equities again, the undervalued stocks may not increase in price.
In fact, they may fall even further.
Just because a good company has a low P/E does not mean it will rise in price anytime soon.
One needs to have patience when value investing.
The same is true in bull markets. Some companies just ride the market wave, resulting in over generous P/Es.
Undervalued or Junk?
Investors value a company’s growth potential in the P/E calculation.
If investors believe the potential for a company is strong, it will have a higher P/E than one whose prospects are weak.
If you focus only on stocks with low P/Es, you may find some undervalued companies. But you may also end up investing in firms whose earnings potential is seen as weaker than in comparative companies.
Separating the value plays from the dogs is always a challenge.
The quantitative analysis may give the same results to two companies. But one may be a value stock, the other a piece of junk. That is why investors should never rely on P/E, or any ratios, on their own. They need to be combined with qualitative analysis.
It is the qualitative, not the quantitative, analysis that separates the good from the bad.
I suggest you never forget that.
Next up, the price-to-book ratio.