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Avoid Value Traps by Understanding Various Valuation Multiples by Industry!

One of the hardest things to do when investing is figure out the proper value for a company.  Sure, “buy low, sell high” sounds easy enough, but with differing valuation multiples by industry, it’s not just a blanket process that you can apply to all companies that you look at.

When I first started investing, I was only a value investor.  To me, that made the most sense, and to many people that is still their preferred method of investing – and there’s nothing wrong with that.  The thing with being a value-investor is that your entire goal is to find a company that is undervalued vs. their intrinsic value.

How do you do that?

I could go into a very long, drawn out explanation about how to find good companies, but Dave actually wrote an awesome post on his stock checklist that you should check out instead.

When I first started investing, I was immediately drawn to the numbers and looking at many of the valuation ratios for companies.  For me, that was just the easy thing to do.

You frequently hear about how Price/Earnings, or P/E, is the end all be all for investing and finding out if a company is valued properly, with anywhere from 15-25 being the ideal range for a stock.

Easy enough, right? 

Turns out there’s actually a major issue with this – the companies that you can select are going to be very limited.  Different industries actually are going to trade at very different valuations.  It might seem wrong at first, but think about it – what is the true value of an up-and-coming tech company?

You probably don’t care about the actual income of that company – you want them to keep growing revenue, increase market share, roll out new, innovative products, and then start to maximize on their earnings.

So, why would you value that company off of a ratio that’s based on earnings, like P/E, the same as you would with a bank?  A bank is much more established and likely doesn’t have a lot of growth years ahead.

You know what it is – it’s a bank.  You’re going to get slow, steady growth and a strong dividend payment.  You’re investing in the bank for stability – not to be your next tenbagger.

So, yeah – the P/E is going to really, really vary by industry.

I found an incredible table from Siblis Research where they break down the different CAPE ratios by industry sector over the last few years.

Before we get into the chart, let’s first explain the CAPE ratio.  CAPE stands for “Cyclically Adjusted Price/Earnings”, otherwise known as the Shiller P/E Method and is commonly used to smooth out some of the volatility that you might see in the market.  CAPE basically takes 10 years of earnings and adjusts it for inflation to normalize the crazy swings that you can see from year to year.

Another important thing to keep in mind that as of June 8th, 2020, the average CAPE of the S&P 500 was 29.73, per Siblis research, so pretty significantly over that 15-25 range.  Let’s look at the chart!

If you were going to only invest in industries that were under 25, you’d be missing out on quite a few industries such as Communications, Consumer Discretionary, Health Care, Information Technology and Utilities!

You’ll notice that Financials and Real Estate are under 15, which might indicate that they are great values, right?  Well, the only thing that I would caution is that just because a company has a low CAPE doesn’t mean that they’re undervalued.  If an entire industry has a low CAPE then is the entire industry undervalued?

Maybe, but maybe not.  That’s the tricky part – and it’s why I recommend you taking a look at the Value Trap Indicator (VTI):

  • The Value Trap Indicator helps you avoid the stocks that are statistically likely to underperform the market.
  • The Value Trap Indicator formula has been back tested through a database of 4,000+ stocks during the strong bull market of the 2000s, and found to consistently identify stocks which underperformed the entire group.
  • It makes calculations that are one step ahead, without requiring hours of sifting through financial statements.

Along with that, the VTI provides many other great benefits:

I personally will use the VTI to make sure that I’m not finding a company that looks cheap but is actually just a value-trap.  It seems so easy to identify but it’s not – unless you have the VTI!

It’s imperative to understand the difference in valuation multiples by industry because it can drastically shape your investing process. 

Think about this: If your target CAPE is < 20, and you’re looking at the Energy Sector, then more than half of companies are going to look undervalued because the average CAPE is 17.47.

But what about if you were looking at Information Technology?  You’re going to struggle to find a company because that industry’s average CAPE is 36.54. 

In a word, it boils down to this – perspective.  You need to have perspective on the relative data of that industry.  You need to understand that if you’re going in saying “I need a CAPE under 20” then you’re going to likely have very few Information Technology companies that you can choose from.

And when you do find one, ask yourself this – Why is that company so much “cheaper” than the other Information Technology companies?  Is it a value or is it a value trap?

Again, perspective is key!

One thing that I immediately wondered when I was looking at that chart was how things had trended over time by industry.  Of course, I could simply browse at it and see the trend, but you know me – I’m not a “browse” type of guy.  I’m a numbers nerd!

So, I just copied that data into Excel and then tracked how it has changed from year-to-year, as shown below:

The thing that immediately stands out to me is the massive decrease that the Communications sector saw from 12/31/17 – 12/31/18 by nearly 15.  It seems that this sector had become pretty overvalued until this point and then has stayed fairly stable since based solely by looking at the chart.

I also immediately noticed that the Information Technology sector has increased every year except for 1, and in that year, all sectors dropped in their CAPE with the exception of Health Care which was relatively flat.

In addition to this chart, I created a second chart that simply shows the total change that each industry sector has experienced over time vs. their starting point on 12/31/2015:

The reason that I like this chart is because I can see how the various sectors have trended in totality vs. 2015.  So, the clear sector that has theoretically become the most overvalued has been the Information Technology while the Communications sector has become the most undervalued with Financials & Real Estate right on its heels.

Another way to take a look at this is to try to put some of these stocks into a stock screener and see what we get back.  Personally, I prefer using Finviz as a stock screener and I know that Dave does too.

When I go to finviz.com and click on the stock screener, I then can make an input for the P/E to be whatever I want.  In this case, I am going to select it to be < 15.  When I do this, it immediately eliminates a large majority of stocks as the screener goes from 6618 U.S. companies to just 735 that have a P/E under 15:

I can then also search by sector or any other data that I think is pertinent to help me find a great company but again, I urge you to really think about if these companies are potentially value traps or not.

The Technology sector has 491 companies in total but only 19 have a P/E under 15.  To me, that’s actually a red flag more so than an indicator that there are 19 companies out there that might be bargains in the Tech sector.  The fact that the amount of companies is so small makes me question:

1 – why are they so low compared to their peers?

2 – should P/E even be the valuation ratio that we’re using when comparing tech stocks?

Question number two is something that I actually think is a very hot topic nowadays and a good one to be discussed.  Andrew and Dave recently talked on the podcast about their opinion on the Price/Book, or P/B, valuation ratio.

The debate on P/B is that it’s an outdated method that was really intended for companies that have a lot of assets.  You’re basically taking a look at the market cap of the company and the assets that the company has and using that to see if the company is overvalued.

When you’re looking at a tech company then this really doesn’t apply at all.  That tech company likely has next to 0 physical infrastructure so their P/B is going to look astronomically high.

I actually was able to find that Siblis Research provided the same exact sort of data but with P/B and I just went the extra step to put it in a nice little chart for you:

A couple things that immediately stood out to me is that the volatility isn’t quite as high as the CAPE ratio which makes sense – your assets are not changing nearly as rapidly as your earnings will.

Another thing that stood out was the wide range – Energy is 1.18 as of 6/30/20 while Information Technology is all the way up north of 9!  That is crazy!

Along the lines of people saying that a P/E of < 25 is good and < 15 is great, I also frequently hear that < 1 for P/B is great and < 2 is good.

So… does that mean we effectively cannot invest in Information Technology companies at all?  Heck no!

To me, that simply just means that we need to make sure that we’re going into any sort of company evaluation with a little bit of background knowledge.  Don’t go into and company evaluation with the thought that it needs to meet certain metrics or you’re going to end up with the same types of companies over and over again.

If you want to use a stock screener, that’s completely fine – but make sure you know what you’re looking for!  Don’t sit there with the thought of wanting to find a good, cheap tech company and then going to a screener like finviz and putting a P/B of 2 into the screener.

Remember how there were 491 tech companies?  Only 120 of them have a P/B of less than 2.  Maybe that’s all you care about (I hope not) but I really just urge you to think about what is really important when you’re looking at different companies – that’s all!

Personally, I think that P/S is the best valuation ratio if you’re looking at with a growth company because it seems like that’s how a lot of those companies are valued.  People don’t care about their assets or about their earnings because they just want them to keep throwing the money back into the company and showing signs of continuous growth.

They want to see revenue (sales) growth because that means that the company is able to charge higher prices, is growing their current customer’s sales, are bringing on new customers or potentially a combination of the three!

Basically, investors are buying into these companies because the sales growth is there and they’re banking on the hope that this means that eventually the earnings will be there as well.  It’s not an awful train of thought, but it does require a certain amount of speculation that you need to be able to stomach.

At the end of the day, there are really two takeaways to this post:

1 – Do Your Own Research

By me doing my own research, I could dive in a little bit more to understand the trends that these sectors are showing with their P/E and P/B ratios.  By doing this, I simply was able to get a feel about what sectors might be a value trap and also get a good baseline of where to look for undervalued companies.  A low Information Technology is likely a very high P/E in Energy!

2 – Compare Apples to Apples

As I just explained, things are not the same by sector, and you need to evaluate them that way.  Make sure that you are looking at companies that are similar and doing like vs. like comparisons.

I have recently started investing in cloud stocks and I think that this mindset really grew when I was looking at those companies.  Seeing a company with a P/S of 40+ isn’t that uncommon because you’re just buying on promise.  Does that mean that you should just ignore all common sense and buy those companies because it’s normal?  Heck no!

But that doesn’t mean that you can’t make money investing in cloud stocks!