Today we are going to talk about stock valuation methods. Andrew has a great ebook that he wrote a while back that talks a lot about how to value a stock. These are methods that I use personally every day .
- A breakdown of the 7 valuation metrics that we use
- P/E ratio and its importance
- P/B ratio and the relevance to value investing
- Debt to Equity is probably the most important ratio
Andrew: There are a lot of different ways you can evaluate a stock, there are a lot of different models. I want to talk about some of the simplest ones that you’ll approach, you can always take the subject a bit further. You can talk to experts, they like to talk about things like EV or EV/EBITDA, that is enterprise value to earnings before interest, taxes, depreciation and amortization. You could do a discounted cash flow valuation you can do free cash flow valuations.
There are all these different metrics that someone can use to really value a stock. some of the most basic ones I actually use. We are going to talk about 7 of them and they’re all part of the seven steps that I wrote about in my ebook. IT is also the same 7 metrics I use for my value trap indicator system. All of these combined are what I use to formulate my approach and it’s the exact same method I use to buy every single stock that I buy.
Now, keep in mind you certainly can use one of these. Some people do, you have the Peter Lynch approach where people just strictly look at a PEG ratio, which can be a combination of two of them that we are going to talk about today. You certainly could use just one, there is the Ben Graham approach, which early one was one that Warren Buffett used which he calls the “net, net” approach. Kind of like, the metaphor they use is picking “cigar butts.”
And they really use a price-to-book, more focused on net tangible assets. This is another variation of a valuation method that we are going to talk about today. My whole point is that you could center on any one of these valuations, I argue that when you value a stock, you don’t want a laser focus on making one ratio that much more important than the others. I think you want to take a complete picture approach, understand that there are three financial statements that every single stock needs to post to the SEC.
The SEC puts it on their website and it’s freely available information to us. A lot of investors will look at one little tiny sliver of the financial statements, completely ignore the other ones and get blindsided when they don’t account for things they aren’t looking for.
We are going to look at the whole picture, all seven of these and not so much that they are all excellent but they are all good enough to where you can feel comfortable that number one we are getting a stock at a good price. And number two, that were are getting a stock that has a great business model, and is likely to continue and gives us gains in the future.
The first method valuation method I want to talk about is probably the most common and every single novice investor knows of this ratio. And that is the Price to Earnings ratio or P/E. What this is going to tell us is, if you think about what a business does, the business will basically spend money and they are going to try to make more than they spend, and that difference is a profit.
And profit really becomes the number one goal of the business, which is something that gets lost in the wash. A lot of people focus on other things, but really at the end of the day, the goal of a business is to turn a profit. Price to earnings ratio helps ensures us that as investors we are getting a fair share of the profits.
If you take a simple example of Shark Tank, which I love to talk about. Let’s say a business owner out there, they produce custom water bottles that are now this new technology and it’s a rage in the fitness community. Just from what you just heard it sounds like a great investment, it’s a trendy industry and everybody’s trying to expand, and all the customers are trying to lose weight. They have an innovative technology and you have a head start on everybody else but if you are really going to invest money and your friend comes over and says “he, Bob over here is selling his water bottle business, why don’t we split the money and buy it together.
The first question you are going to want to ask is how much money is he making? Because a guy can have water bottles and it costs $20 to make a water bottle and he only sells them for $25, you are looking at only a $5 profit Sure he could maybe sell enough which would be a good sign of a business model, but if he is only selling a 100 of them a day and you are trying to buy a business for thousands of dollars, and now it doesn’t make a lot of sense.
What it comes down to, how much is Bob going to sell the business to us for and how many earnings are we going to get out of it? Dave, if you and I were going to Bob to buy the water bottle business, and he is selling the business for $100 and he is making $20 of profit per year. Since I am splitting with Dave I am going to be putting in $20 a year and I will get back $10 every year. So in five years, I am going to make my money back, if the company is able to grow, or expand and make more factories like the one behinds us. With the money we get from the business we can spend it on marketing, get more exposure to the business and sell more units. Then I could get my money back sooner.
Now, if he was selling the same business to us and instead of a $100 he wanted $10,000 now all of sudden even though the profits might be great, that is such an expensive price for us to pay that it just doesn’t make any sense for us to buy the business. Because even if the business doubles and is able to make twice and sell twice as many water bottles as before. It’s still going to take years, maybe decades for us to get our initial investment back.
When you relate what the price of a business is to how much profit is making in the simplest fashion that is what a PE ratio is. The reason why is a ratio is that it all comes down to the numbers. A business that makes twenty dollars a year and a business that makes $20,000 a year just because the scale is different doesn’t mean necessarily that one is better than the other. You always want to compare it to how much you are paying. Because you are comparing it, that gives you a better sense of how much of a deal you are getting. On the most basic calculation, where you are doing price divided by earnings and that will give you the price to earnings ratio, the PE ratio.
There are three other price based ratios that we are going to talk about today. All four of them, including this PE ratio, are all calculated in the same way. It is a simple mathematical equation, we’re taking a price on the top, we’re comparing it to one of the metrics that we can tangibly look at. And we are just comparing it to see if it is a lower ratio, which is more favorable for us.
In our water bottle example, if we are paying $100 and it’s making $20 in profit, you take $100 and divide it by $20 and we have a PE of 5. If Bob has stars in his eyes and licking his lips at the next Lamborghini that he wants to buy and he doesn’t think that we are smart investors and he thinks that he can take us for a ride. He’s maybe going to try to sell the business at $10000 and if it is still only making $20, suddenly instead of a PE of 5, we have a PE of 500. So that is the difference, a PE of 5 versus a PE of 500. the PE of 5 is lower and it’s likely a better deal for us because we are paying less of a price compared to what the earnings are. In the stock market, you generally want a lower price to earnings ratio, generally as low as you can get it.
Dave: Exactly, the interesting thing about the PE ratio is value investors love the PE ratio. It is a nice, easy, quick and dirty way of getting a general view of whether the stock is priced accurately or not. By that I mean, generally the lower the ratio is the cheaper the stock is and the more we can look at buying it. Anything, in the 20 to 25 range is acceptable, once it starts getting above 30 to 35 and 40 then it is becoming way too expensive. We talked about Amazon last week, and its PE ratio is I believe 139, so it’s just astronomical. I believe Microsoft’s is 65 right now, these are two huge, very well known companies but their price that people are paying versus their earnings, you are paying a premium for those earnings, that is where people can get in trouble with some of these stocks. This is why this ratio is important, it’s not the end all, be all that some people can make it out to be. It’s a great starting point, Andrew earlier mentioned, which I really liked, that these metrics are a great overview to give you an idea of the financial health of the company, and to see where it is. And also to help identify warning signs that may indicate that maybe this is a company to be wary of. It may be something you like and want to keep on your list, but you may buy it down the road but right now it is just too rich for my blood. You go to the BMW dealership and you see a car you really like but you pass on it because it is simply too expensive right now. You wait until you can find a used one or maybe you buy next year’s model.
The other thing I wanted to mention about the PE ratio, there are a lot of different ways to calculate it and we are not going to go into to those today, but the PE ratio of the S&P 500 right now is I believe around 25 or so, which is really, really high. The average is around 17, so it’s higher than it normally is. You hear a lot of talking heads on the news about the stock market keep going up and up. And yes, it does and so does the PE ratio because people are paying more for the earnings that are being produced. They are paying more for the profits that a particular company is generating. As it gets higher and higher you start to get into stock market areas where it could crash or have a big drawdown. And those are times where we can jump in and buy things as value investors because we are looking for deals on companies.
This is another area that the PE can come into play, is that it can help us see when things are overvalued for a really good company and when there is a correction in that price, then we can take advantage of that. For me, that is where a PE ratio can really come in handy.
Andrew: Yeah, I have seen some success with just the PE ratio when I just started out. I think this was a company that you might have talked about before, Corning (GLW). I remember they were one of the first stocks I ever bought, I also bought Microsoft as my first. I bought Corning, that was my first Benjamin Graham stock and it was very undervalued for quite some time. I don’t remember what the exact PE ratio for it was but I do believe it was under a 15 when I bought it. the PE ratio stayed low for a while, and even today it is below 20. When I bought it, one of the criticisms of this stock was that it had been flat for a very long time, it was flat for two or three years. But being confident in this Graham philosophy I went ahead and bought it. And within the first year it I think I made 60 or 70% on it and I think at one point it did double.
This is just one small example and there countless more you can screen for. Right now I am on the S&P 500 on my stock screener and sorting through the lowest PEs you have companies like eBay is at a 5 right now, General Motors and Ford are both below 10. Generally, different industries tend to trade at lower pe ratios, which is a whole another topic for a different day. You can even compare a PE to its competitors, you can see one pe lower that another that might be an indicator that one company has an advantage over the other, as far as an investment philosophy goes.
Dave made a great point about the PE being really high today, don’t let that deter you from thinking that there aren’t low PE or these other ratios that we will talk about that are favorable. Don’t think because we have seen all this success for all of these years that you can’t find great opportunities in the market today.
Dave: You definitely can find great opportunities today, I am not trying to scare anybody off from what I said earlier. I was just trying to breathe a word of caution into everyone. There is a phrase that I like to talk about in regards to the stock market. As a general rule, “irrationally exuberant” from Robert Shiller. To me when I say phrases like that I am meaning that instead of looking at the whole stock market I am referring to focusing on that one company, and take that into context. As opposed to what the whole market, because you are not buying the whole market, you are buying Corning or whoever else you are looking at.
There are tons of good companies out there that are out of favor for whatever reason that have a low PE ratio and might be a great opportunity to get into. That is where these metrics can help you down that path. You can use those metrics to screen and find companies that would be good investment opportunities. The stock market can be irrationally exuberant, there are people that are going to get excited about the flavor of the moment and they are going to come in and out of that. And you never really know where it is going to go. Our job is to find deals that we can buy with a margin of safety that will be great compounders for us as time goes on. Eventually, the stock market is going to find these deals and they will become more popular, which will drive up the price. This is where you can take advantage of that.
Andrew: That is probably more important to know about these ratios is exactly what you just said. Is that it can find us great deals when they are low when they are high that is absolutely a big, red flag and we just want to avoid that at all costs.
You know how Dave and I like to make Amazon (AMZN) our whipping boy, there’s plenty of other companies out there that have PEs over 100 right now which is absolutely absurd. and even a PE like 50 or 40 when Microsoft hits its peak in the late 90s, it was one of the biggest if not the biggest stock as far as market cap for that time, but the PE was very high. even though it was a fantastic business and although Apple (AAPL) has made its mark it still has not been able to touch Microsoft when it comes to the business side of putting all these pcs in people’s offices, they way they have been able to compete in the video game space, and so many different aspects, not even to mention all the software licenses they have and the way they are changing the Microsoft office to a subscription, which I think is brilliant. even with all this great business success, their PE was over 50.
From that 1999 high they crashed about 50 percent when the stock market went through its crash and it has taken them from then to 2017 to finally catch from where they were at their peak in 1999 to today in their same market cap. We say that we will hold for the long-term and things will work out even with a high PE. but consider in that same time period you had the S&P 500 average 7 to 8% a year during that time and if you would’ve just bought the Microsoft investment with the high PE, your investments would have stayed flat while the rest of the market went up and continued to compound.
Do not take Dave’s warning lightly about having high PE ratios and that being an indicator of an investment you want to stay away from. It’s a really big part and a big warning sign for not just a PE ratio but also the rest of the valuation models that we are going to look at. We look at them for a reason and they can signal trouble a lot more than they might signal opportunity.
Dave: To tack onto to the comment about the warning you were just discussing. I want to throw out three companies that I was just looking at while we were talking. Just to give you an idea of maybe some of the stock darlings out there. Netflix (NFLX) has a PE of 346, Tesla (TSLA) has no PE, it’s actually negative, so that $250 a share you are paying is buying negative earnings. Think about that for a moment.
Then we have Apple who has the largest PE in the market and in history right now their PE is a little over 17. You do the math, that to me is a no brainer. If you look at the first two companies, they would scare me off, way too rich for my blood. I am not saying they are bad companies, and that I don’t love their products. I am a huge fan of Netflix, but would I invest in them? No way, just way too expensive for what you’re paying for. To put this in perspective, if you bought a car valued at $10,000 if the same car had a PE ratio of 346 you would be paying 346,000 for the same car! Who would do that? No one would, that is just crazy.
I am not saying you should never buy Netflix, but at these prices, there is just too much opportunity for it to go bad. Another strike against them would be that they don’t pay a dividend. Your opportunity for retirement income would be when you sell the company, which means you are relying on selling at the right time.
Andrew: History proves it too. I have a couple more examples of this in my ebook that is available for free. The Seven Step ebook and history have proven over and over again that these principles are principles for a reason. You talk about dividends which are a perfect segue into one I wanted to talk about next.
Dividends and how we can use that to evaluate a stock. I’ve talked several episodes, and if you haven’t I recommend you go back and listen through the whole archive so you can see the progression of the different episodes and different topics. This can help you build on your foundation brick by brick. As you build these bricks and see how the stock market works. Obviously, I am so incredibly passionate about dividends. I try to do a Netflix session weekly with my dividends, at least once a week. Gotta show the love for them, in my opinion, if you don’t have a dividend you don’t have a good investment.
Number One, we want to look at stocks that are paying us a dividend. We want to see if it’s giving us a good yield, that’s always a good bonus. I look at yield, but I don’t always discriminate against a company if it doesn’t have a great yield. If a company has a low yield. What I care more about is that the company has a good payout ratio and that the company is growing its dividend.
When we talk about payout ratio and let me define that real quick. The payout ratio is simply how much a stock or company is paying out from their earnings to shareholders as a dividend. We talked about earnings in the first valuation model. the second one is how much of that do they pay back to us. We basically want to see is a higher isn’t necessarily bad, but you don’t want a payout ratio that is higher than a one. If you do the calculation, its an another simple division, it’s going to be dividends paid divided by earnings per share.
How big the dividend payment is per share divided by the earnings per share. If the dividend is higher than the earnings then that means that payout ratio is going to be a one, which is completely unsustainable. I mean how can a company pay out a dividend and payout out what is more than they earn. They either are burning through cash or are taking on a lot of debt. We don’t want companies that have a super high payout ratio and we want to caution and just monitor a company that just recently jumped up in payout ratio and if it’s a trend that continues that could be troubling.
A payout ratio will give you an aspect of growth in a way. If we got the second part of dividend growth taken care of, and if the earnings aren’t growing then you are going to see that payout ratio increase and eventually, it will get above a one, which is going to be a problem. The payout ratio is one way to make sure the business is growing and it’s keeping up with its growing dividend payments. And it’s telling us that profitability is healthy and healthy enough to pay a dividend so we can be relatively confident that their dividend payments will continue and hopefully even increase over time.
Dave: Dividends are our best friend and as I’ve said before it’s the friend that keeps on giving. Looking at the payout ratio is so important, Ben Reynolds mentioned that during out interview with him as well. You are looking for a payout ratio that indicates that the company still will have money that they can use to reinvest in the business. If the company is paying out all of their earnings or are close to paying out all of their earnings.
In the short-term that is great for the shareholders, but if things go wrong with the business and they don’t have enough money to fix something, buy something, make an acquisition, anything that may come along. And if they have to borrow money to do these things, that is bad, we don’t want that. Like Andrew was saying as they look at the payout ratio and it gets closer to one then they are going to start to have to borrow to continue that payment, which is unsustainable.
To use Apple again as an example. If you look at Apple, their payout ratio is 25% and their dividend yield is lower at 1.56, which is not great and they don’t have a long history of paying a dividend. They have a ton of cash on their balance sheet right now and they are flush with money and they have the ability to give it back, but being that they are a tech company they also spend a lot of money on R&D, research and development trying to come up with the new iphone or whatever it is that they are trying to create. whether it is an electronic car, or being able to fly us the moon and back in two seconds, you never what they are going to come up with.
The point of all of this is that dividends are our friends and we want to invest in companies that pau us a dividend. One of the cool things about dividends is an addition to the great compounding that it can give to us. It can also become a source of comfort wit the company, in the fact that the longer they pay a dividend the more they are going to want to continue to make that dividend. You are going to want to continue to pay that dividend going forward. And this process becomes a self-supporting system because they know that stockholders are going to buying a share in their business because of the focus that they were given. This will continue as they go along and as they grow their dividend the more investors will take notice.
Paying a dividend will become more of a focus and will grow in importance and will become a self-fulfilling policy. this will become something that they will want to continue growing over time. These are the companies that we want, companies that are shareholder friendly and that is a dividend becomes so important because we are looking at a company that is looking out for us.
As we have talked about before when we take our hard earned money and invest it into that company we expect a return on our investment. The dividend becomes one of the things that we look for. the dividend becomes one of the ways that they can pay us back for the initial investment. If even if the company has a poor year, you still have the dividend that you are still going to be receiving from the company. that is key to investing.
Andrew: You mentioned Apple kind of having a lower yield and I can’t remember if I have mentioned this before. If you look at a company like Walmart (WMT) back in 1987, their yield was only .44 % and they were one of those companies that continued to work and grow and their dividends. If you had put $10000 into Walmart in 1987 you fast-forward a couple of decades it would have been over $245,000 during that time.
Dividends are very important and getting that growing aspect is very important as well. I like to see some sort of track record of growth, higher percentages of yield if we see some growth if can help us be confident that a company that pays a dividend now will more likely to pay a dividend down the road.
Next, a model that we should look is earnings growth. I mentioned the PEG, which is the ratio that Peter Lynch popularized. It’s one ratio that you can use, it adds a growth component to the PE ratio. I like to look at earnings growth on its own, and you basically want to make sure there is earnings growth. It is not like one of the price ratios where you have a set standard and its not like payout ratio or debt to equity were there is generally accepted numbers by experts as to what these numbers should be.
Earnings growth and how people look at it is kind of like the Wild West right now. There are so many varying ideas about what is good, what’s not. There are so many different ways analysts look at quarter over quarter, or quarter versus estimates, too many to mention. You look at the analysts, stock pickers, and hedge fund managers for guidance. It is really hard to give a set number on what growth is good. I really like to look at growth over a long time period and I think that differentiates me from a lot of people who look at growth. I like to look at it over a very long time period and I like to see the growth that is consistent every single year, it doesn’t mean it has to grow a certain percentage each year. Ideally, over enough time, it should give us superior growth over that time.
I’ve done some research from the past and I’ve looked overtime to see what worked back then and are there any correlations from and what kind of things can we deduce from this. Ben Reynolds wrote an article which matched up perfectly with the research I was doing at the time. There are 15 stocks that all averaged over 16% or more per year, as far as compounding the share price. And a big percentage of them, not all, but a big percentage of them had double digit growth per year averages. Not to say that it is a panacea and that dividend growth is going to mean that you’re going to have fantastic results all the time. But it is a good thing to screen for and one of those things to look into.
If I am comparing one stock that looks cheap compared to another that I was looking that is much more expensive. If look at two stocks that are priced similarly and the growth of the first stocks is over 10% and the other is only 2 to 3%, then you are probably going to want to go with the first stock. Because that growth is there, the trains don’t last forever but the best thing we can do as investors because we don’t have a crystal ball is to look at the past because that is all that we have to go on. Try to make the best guess based on our knowledge of the past events. The best idea is to buy enough stocks to last for the future and to help protect us in case any of our trains crash but I think looking earnings growth over a long time period and trying to find more, more is better.
Dave: I love the ten-year approach. I was thinking about this a little bit today and there was this article in the Business Insider about the recent IPO of Snapchat (SNAP) and the analysis of the IPO and this company, they were also putting the money behind the IPO, made some errors in their calculations. They did go back and make some adjustments to their errors, they did make some changes to their financial documents, but they didn’t change their price that they were recommending that people buy at.
I guess the point that I am wanting to make with that is earnings are a great thing to look at. but keep in mind that it can be manipulated and it can be a dangerous game if you play it quarter by quarter. One thing that you will notice about the stock market as you start to get more into this and follow it. People wait with baited breath for every quarterly earnings report and they base their buy decisions solely on this recommendation from an analyst.
Whatever the market may think of that particular company at that particular time. and the reason why that can be a dangerous game I will compare it to my friend baseball. Baseball season started on Sunday and my favorite team the Giants spent $60 million to go out and buy a closer, a pitcher who pitches in the last inning of the game and help finish the game off for the team. They were winning the game going into that inning and he had a very bad game and gave up two runs and they ended up losing the game, just like so many games last year.
As a baseball fan, I know there are another 161 games to go and that they weren’t going to win them all this year, so I just took it a with a grain of salt and thought its only one game. Sure enough, they won the next day and the pitcher in question pitched great. but if you were going to overreact you could freak out and sell your stock based on that one particular day, based on the earnings that you saw for one particular quarter.
Doing what Andrew is recommending and having a long-term view of that gives you a much better outlook of the company and you can manipulate, fake and rely on somebody else on the earnings to make your decision to buy or sell the company based on a very short time period. Three months in the business world is infinitesimal compared to a 10 or 20 year time period.
A company that big can’t make changes that are going to affect real change in that company in just a three month time window. Think about where you work and when the enact some new change, how long does it take to get comfortable with that change and it makes a difference. Depending on what the change is it could take months to a year before the changes are even flat. So basing your reaction on what happens in a three-year time period is maybe not the best decision.
Looking over a ten-year time horizon that is really going to tell you what the company is doing and where they are going. I will be real honest with you, I go back and forth on the whole earnings thing and I think it is a great thing to look at, but I guess as I’ve read more about the stock market and some of the things about the shadiness that has gone on with some earnings reports, I guess I get a little bit jaded about it, especially in the short term. I think in the long-term I think it is absolutely critical to look at but if I am looking at it as a decision on based on the three earnings report I would probably pass on that unless there was some drastic change or earnings drop brought on by some event.
Since we are talking about earnings I was curious where does Andrew go to find that kind of information?
Andrew: Number one you can go to SEC.gov and you pull up annual reports, I have a blog post about how to read that if you are not aware. And, lately, I have been using a website that helps me take the data from the annual reports and puts it in the program so you can see quite quickly what the ten-year numbers are. I’ve made a spreadsheet that helps me with those calculations. I like to automate things like that. That is one way to do it, but I caution using that site because sometimes they make mistakes and if you are going to make an investment decision based off of those numbers make sure you double check before pulling the trigger. Make sure you check the source, sec.gov, to make sure you have the right numbers before making any decisions.
Andrew: Price to book ratio, very similar to price to earnings but instead of looking at the income statement this ratio is going to look at the balance sheet. The easiest way I can describe this is, earnings is a companies paycheck that they bring home, their book value is going to be their net worth. It is literally that simple of an equation. Book value is simply how much a company owns mines it owns, just like we might have a mortgage, retirement accounts, and your net worth is going to be your assets minus your liabilities. The liabilities being the debt that you owe, it is just like that with a company.
Assets minus liabilities, where the price to book ratio comes into and this is where Benjamin Grahm got most of us started and really thinking about this ratio. To give you an example, earlier I talked about Corning and in addition to their low PE ratio, they also had a very low price to book ratio that was below one. Combining the two ratios made it a great buy, I like to think that Benjamin Graham would have been proud, turned out to be a great buy.
For a price to book, you are just basically looking at the what the book value is and we are buying at what the company’s net worth is. If you can get a price to book ratio under one, that means you are paying less of a price than what it is worth on its books. In a worse case scenario and the company had to liquidate, you would actually, in essence, be getting more money back that what you paid because once the liabilities are all paid there is a certain amount of assets left and then it gets distributed to the shareholders.
If you can buy at a price to book below one, all of sudden you could just be making a return off of the return alone. That’s the general idea of the price to book ratio. You are trying to get a good deal based on what the companies worth. When we talk about assets we are talking about the property, equipment, things like the real estate they own, the inventory. Basically, anything that helps the company make a profit, that is going to be an asset. Of course, why wouldn’t we want businesses that have high assets, high assets mean high earnings and it just self-perpetuates into nice gobs of cash for investors. The lower the price to book the lower price you are paying compared to how much book value you can get, and obviously lower is better.
Dave: So what would be the with this metric you would be willing to go before it would scare you off.
Andrew: That is a good question, and I talk about this and I really put a formula to it in my value trap indicator book and that is next level kind of information. It is kind of like a sliding scale I don’t put a hard and fast rule on it. I don’t set any sort of actual number, but the further away you get from the norm the worse it gets. A 1.5 is something that is kind of the middle point for me and below that I am ecstatic and above 1.5 I start to get cautious. that is not to say that I won’t buy a company above 1.5 prices to book but I bought Hormel (HRML) a while back and it was at the time barely under 3 and that stock has returned me 40% or so since I first purchased it.
Again, lower is better but what we really want to avoid is that point you made with the PE ratio you really want to avoid really high ratios. The price to book, if it’s really high it means you are not getting very many assets and likely paying a high price and high valuation on what the business is actually really worth. So you want to avoid that because a high valuation usually means that the bubble will pop one day.
Andrew: Price to sales is similar to price to book basically were going to look at sales that are on the income statement. It is a revenue metric, if you think about a company needs to turn a profit but they can’t turn a profit unless they get sales first. The price to sales makes sure that everything is ok, you talked about earnings manipulation which I think is the fantastic point, and one way to mitigate that is the make sure that your price to sales is low.
If you have a very low price to sales and a low PE ratio there is a chance that the company the company could be manipulating earnings. Very similar to the price to book ratio you want to find something below one is fantastic, anything around ten is going to be terrible and definitely a red flag, And again around the same range as the price to book. In the range of 1.5 or so, maybe as high as 3, but not above that. That would be the heat map of these ratios that we want to use.
A guy named James O’Shaugnessy, which is one of my big influences, wrote a book called “What Works on Wall Street”, he looked at going into past research, back into history and what kind of simple ratios like we are talking about. What kind of simple valuation models really did well over the long term. He found that combining both prices to book and price to sales, those two combined actually outperformed pretty much everything else. Again the past isn’t going to be a forecast of the future results, but it is a good indicator based on this kind of research and it logically makes sense as well.
Dave: Well you know we don’t know the future so we only have the past to go off of as a guide. That is a great point. the thing that I like about all the stuff we are talking about today is that we are looking at all of the different statements that a company will put out in their 10k and 10Qs, with the balance sheet, income statement and the cash flow statement and this is where you can start to get into the nitty-gritty of the company.
And using these formulas and ratios that we are talking about can help you start to dive into those statements to help you learn more about the company. I know that all of us are not finance majors and a lot of us as well myself did not go to school for finance but this is how you can start to learn these ratios and where these numbers are coming from. Because that gives you a better in-depth idea of what’s going on with the company.
I know when I start doing analyzations and writing articles about particular companies I like it so much because it gives me a great dive into the companies as opposed to reading a little bit about it. I start to really dive into the numbers to figure what is really going on. You start to see patterns and it really becomes kind of a fascinating book that you are learning more about the company when you start reading the numbers of the company, they start to tell you a story.
That to me is what becomes so interesting about the company, you read about how they are changing a particular item or they are coming out with a new product and you can see that the R&D has been working on this product and now that is going to affect certain things in the statements as well. To me, how they are all intertwined is so fascinating.
Andrew: Yeah, I love how you say you don’t have a finance background, I don’t have a finance background, even though I may be able to sound really intelligent and it is something I am very passionate about but I have been digging into this kind of stuff for quite a while. I really want to make the clarification that when I started out it was in 2012, I didn’t know a thing. I am an engineer by trade, the most exposure I had to the stock market was Motleyfool.com. I didn’t know any of this stuff, but what really drew me into this stuff was if you notice that every single ratio we have talked is super basic.
Even thought my ValueTrap indicator spreadsheet is complicated, but when you first get started and start to understand the concepts and what we are trying to teach here. It is all basic math, it’s all simple pieces of the balance sheet or the income statement. Everyone can understand profit or a dividend you can understand that. Asset and revenue you can understand. We’ve got two more left to go today and those are very simple as well. You don’t have to pull out some sort of all-night cram session where you are looking at 50 screens and pick apart all these different pieces of information and trying to put a puzzle together.
It’s like Dave said, it is like reading a book, it’s just starting to what you can understand and slowly try to absorb it and having seven steps is something that is very digestible, like having seven days of the week. Something that we can really remember and put to our mind. You can chase the rabbit hole as far down as you want to go. But if you have these seven understandings that we are talking about here. That is going to put you far ahead of so much of the competition.
We talked about the discrepancy in the PE ratio, you had the Apple which was reasonable and then you had Netflix and Tesla that weren’t. There is such a big portion of the market that is not even looking at a simple ratio like the PE and using that as part of their investment philosophy. You can really find an advantage and understand these things and try to apply them to your own situations. To whatever scale may apply to you I think it would be very helpful.
The next category I want to talk about is the debt to equity. This is less of a valuation model per se, it is more a red flag indicator. I have done research that spans back over the past century and looked at all the major bankruptcies, the biggest ones that we have seen. I plugged them all into my spreadsheet, my VTI spreadsheet, and what I found was that a high debt to equity is a high indicator of risk and bankruptcy.
All a debt to equity ratio does is tell us how risky a stock is and in general, we want to stay away from stocks that have a high debt to equity ratios. The equation is quite simple, you just take total liabilities and divide it by the shareholder’s equity, you are literally doing what the ratio suggests. Equity is the same as book value like we said it is the net worth of a company. the average debt to equity is a one, obviously, anything below that is nice and as you get higher it’s like a sliding a scale and you get more and more cautious as it climbs. That is really all there is to it like I have said research has shown that the 30 biggest bankruptcies all showed a very high debt to equity ratio. These are some of the things that stood out to me when I was doing my research.
Dave: And it was very illuminating in your book, I remember reading in your book about some of the companies that you highlighted. Obviously, Enron was one that everyone has heard of, that whole situation could have been avoided if you had paid attention to the massive debt load they were carrying. It is amazing how using your VTI index how you would have seen what was going on and could have avoided that heartache.
I work in the bank world and I see on a daily basis people with way more debt than they can handle, they have credit card payments, mortgages, car payments, and they have debt everywhere and they struggle to keep their heads above water. The same rule applies to a company when you buy a company or borrow money to make improvements in their business they have to pay that back.
And as the interest rates go up or down that affects their payments and the higher debt that they have the more impact that is going to have on the earnings of the company. And an impact on earnings is going to impact how they pay us back for investing in their company. They will also have less money to reinvest back into the company or do any sort of improvements. It becomes a sort of cycle, and it can be so dangerous and this is one of the absolute first things I will look at when evaluating a company. If the ratio is high for any company, to me that is a sign that I need to walk away, that is a deal killer for me. Of all the ratios that are the one that I am absolute on because debt can be such a killer of a business.
Andrew: And nobody really talks about the debt to equity ratio either. Which boggles my mind.
Dave: It has such a huge influence on the health of a company, just like our own personal lives. If you have a lot of credit card debt, it can be such a burden to your personal finances. Extrapolate that over the millions or billions that your company deals with and it can be such a burden to the company.
Andrew: They could use the debt payments that they use to service their loans, or they could use that money to invest back into the company or pay us back in the form of a dividend. There are so many things a company can do without a debt burden. More debt can power higher earnings but it comes with a risk. I think Warren Buffett said it best “you don’t know who’s swimming without their pants on until the tide goes out.” that is really the case with a lot of these companies with high debt to equity ratios, people will laugh at us now but wait until the tide goes out.
Andrew: Price to cash is the last metric we will talk about today. I like super, super simple and the purpose of cash is kind of what I talked about before, where if a company is trying to pay out more dividends than its earning it means they have drawn from their cash balance. And in the same way if there are hiccups in the business, things come up, a year of bad earnings, they will have to go to their bank, they will have to use their credit to raise the funds. I don’t think a lot of people look at the cash flow statement like I do.
There are different ways you can value a stock in the way that cash is flowing in and out from year to year. I just simply like to look at cash as an emergency fund. A company could leave the cash in the bank for an emergency, or they could use that many to invest in trying to grow that cash balance or buy more equipment. Warren Buffett has taken quite a bit of his cash and used it to invest in or purchase other companies to try to grow the value of his business.
That is going to do it for today’s session. Thank you for taking the time to listen and or read this session. As you can tell, Andrew and I were very excited to talk about these metrics and how they can be put to use, and help you with your investing.
The use of numbers is so important and these metrics are simple, straightforward and easy to use. As I mentioned before I use them every week and they have been a tremendous asset to my investment strategies.
If you have any questions about anything we discussed today, please reach out to us.