Early this year during a dinner discussion, a high-level manager at a well-known brokerage firm announced to the table that within a few years “value” managers [e.g. Warren Buffet] will be extinct, and that the greatest fear he had about his personal portfolio was that there were “value stocks” hidden within it.
I held my tongue that night, but said to myself “if even seemingly intelligent and powerful street executives believe this nonsense, this has to be the top for growth stocks.”
Sure enough, within a few months, the mighty NASDAQ had declined over 30%.
I am not saying “value” stocks are always better buys than “growth” stocks. What I am saying is that investors and investment managers can no longer afford to ignore the concept of valuation. The past six months has illustrated that it is possible to pay too much for even the very best managed and fastest growing companies. This contradicts the numerous investors who have recently dismissed as irrelevant the procedure of attempting to estimate whether the price of a stock was appropriate.
There have certainly been successful “growth-stock” managers in financial history. Traditionally, these investors who bought seemingly expensive, high-growth stocks did so because they had carefully forecasted significant periods of rapid growth, and using the fundamental framework of absolute valuation showed that what seemed expensive was actually attractively priced over their forecasted horizon.
In contrast, recent investors in growth stocks simply sneered at fundamental valuation procedures, relying instead on ad-hoc measurements, “relative valuation” and “momentum.”
Numerous professional analysts churned out reports that were more advertising than research. Typically, company assessments were repeated almost directly from management’s own PR team. Attempts to justify prices of stocks were often farcically pulled from thin air: “price to pageviews” is perhaps the most humorous, but even “serious” valuation studies were seriously flawed by their reliance upon “relative valuation.”
Relative valuation the process of comparing the value of one company to the value of other similar companies, begging the question of whether any of the stocks in question are fundamentally worth their current price. While potentially providing some value, relative valuation is at best a secondary method, and can be subject to distortion and abuse.
The analyst’s relative valuation pitch typically goes something like this: The market is trading at a P/E of 25,Company X’s industry trades at a P/E of 35, Company X trades at a P/E of 50. “We believe Company X, with its quality management, industry leadership, and excellent long term prospects deserves to trade at a 100% premium to the industry multiple, implying a 40% upside.” Note that in the typical relative valuation analysis, no coherent explanation is offered to connect or justify the P/E’s of 70, 50, 35, or 25, and the basis for the premium forecast is typically arbitrary. We may know that high growth justifies higher valuations, but such analysis never tells us when high is too high.
In the present market situation, the big problem for analysts who rely upon relative valuation is this: given that most of the stocks of an industry or sector in question have declined, how can they ever decide when the price of a stock is truly and fundamentally attractive? If the company leading an industry has declined to “cheap” valuations, would an analyst admit that his favorite stocks should decline to similarly cheap values?
At some point, clients will demand of analysts that they provide fundamental valuation analysis, capable of estimating “absolute” value, little affected by the fluctuating values of the market or industry peers. Analysts who attempt to measure fundamental value forecasts both a company’s short term and long term growth of sales, profits, cash, and dividends. Then they plug these estimates into valuation models or spreadsheets that calculate a fair current price for the company’s stock. This hardly ensures a certain answer, because estimates of future growth are uncertain. But at least an analyst can see that if he’s predicting 50% growth for years, and his model shows that 100% is required to justify the current price, then either his estimates are too low, or the stock price is too high.
Now that the U.S. stock market has experienced two major declines this year, throughout which analysts seemed to duck and cover, unable to explain what was going on, investors should and will demand better analysis. Investors should look for research that incorporates fundamental valuation analysis, as a check against the risk of owning too much hot air in their portfolios.
Links related to valuation:
- Beware of The Market Where All Stocks Are ‘Above-Average’
- The homepage of NYU professor Dr. Asworth Damodaran, featuring valuation spreadsheets freely available for download. http://equity.stern.nyu.edu/~adamodar/
