Stock Valuations And Investment Decisions

By M. Isi Eromosele

Obtaining a standard of performance that can be used to judge the investment merits of a share of stock is the underlying purpose of stock valuation. A stock’s intrinsic value provides such a standard because it indicates the future risk and return performance of a stock share. The question of whether and to what extent a stock is under- or overvalued is resolved by comparing its current market price to its intrinsic value.

At any given point in time, the price of a share of common stock depends on investor expectations about the future behavior of the security. If the outlook for the company and its stock is good, the price will probably be bid up. If conditions deteriorate, the price of the stock will probably go down.

Let’s look now at the single most important issue in the stock valuation process: the future.

Valuing a Company and Its Future

In a fundamental analysis of a company, it’s not the past that’s important but the future. The primary reason for looking at past performance is to gain insight about the future direction of the firm and its profitability. While past performance provides no guarantees about future returns, it can give you a good idea of a company’s strengths and weaknesses.

For example, it can tell you how well the company’s products have done in its marketplace, how the company’s fiscal health shapes up and how management tends to respond to difficult situations. In short, the past can reveal how well the company is positioned to take advantage of the changes that may occur in the future.

Because the value of a stock is a function of its future returns, the investor’s task is to use available historical data to project key financial variables into the future. In this way, you can assess the future prospects of the company and the expected returns from its stock. You should be especially interested in its dividends and price behavior.

Forecasted Sales and Profits

The key to a forecast is, of course, the future behavior of the company and the most important aspects to consider in this regard are the outlook for sales and the trend in the net profit margin. One way to develop a sales forecast is to assume that the company will continue to perform as it has in the past and simply extend the historical trend.

For example, if a firm’s sales have been growing at the rate of 10% per year, then assume they will continue at that rate. Of course, if there is some evidence about the economy, industry, or company that suggests a faster or slower rate of growth, the forecast should be adjusted accordingly.

Once the sales forecast has been generated, your attention can shift to the net profit margin. You want to know what kind of return on sales to expect. A naive estimate can be obtained by simply using the average profit margin that has prevailed for the past few years. Again, it should be adjusted to account for any unusual industry or company developments.

Forecasted Dividends and Prices

At this point you have an idea of the future earnings performance of the company. You are now ready to evaluate the effects of this performance on returns to common stock investors. Given a corporate earnings forecast, you need three additional pieces of information:

• An estimate of future dividend payout ratios
• The number of common shares that will be outstanding over the forecast period
• A future price/earnings (P/E) ratio

For the first two, unless there is evidence to the contrary, you can simply project the firm’s recent experience into the future. Payout ratios are usually fairly stable, so there is little risk in using a recent average figure.

Or, if a company follows a fixed-dividend policy, you could use the latest dividend rate in your forecast. It is also generally safe to assume that the number of common shares outstanding will hold at the latest level or perhaps change at some moderate rate of increase (or decrease) that’s reflective of the past.

Getting a Handle on the P/E Ratio

The most difficult issue in this whole process is coming up with an estimate of the future P/E ratio, a figure that has considerable bearing on the stock’s future price behavior.

Generally, the P/E ratio is a function of several variables, including:

1. The growth rate in earnings

2. The general state of the market

3. The amount of debt in a company’s capital structure

4. The current and projected rate of inflation

5. The level of dividends

Generally, higher P/E ratios can be expected with higher rates of growth in earnings, an optimistic market outlook, and lower debt levels (less debt means less financial risk). The link between the inflation rate and P/E multiples is a bit more complex.

Usually, as inflation rates rise, so do bond interest rates. This, in turn, causes required returns on stocks to rise (in order for stock returns to remain competitive with bond returns) and higher required returns on stocks mean lower stock prices and lower P/E multiples.

On the other hand, declining inflation (and interest) rates normally translate into higher P/E ratios and stock prices. It can also be argued that a high P/E ratio should be expected with high dividend payouts. In practice, however, most companies with high P/E ratios have low dividend payouts. The reason: Earnings growth tends to be more valuable than dividends, especially in companies with high rates of return on equity.

A useful starting point for evaluating the P/E ratio is the average market multiple, which is simply the average P/E ratio of stocks in the marketplace. The average market multiple indicates the general state of the market. It gives you an idea of how aggressively the market, in general, is pricing stocks.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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