Seeing the Value in Stocks Today

There are a lot of measuring sticks that can be used to value people, goods, services, and investments. Using the wrong measure, even when that measure is used accurately, can lead to poor or even disastrous decisions. I have read a lot of bad financial advice lately, but most of it would not be bad all the time. The ability to match up general guidelines to specific situations is key to investment success.

A lot of pundits are saying "stocks are overvalued." Even if true, this statement is so general as to border on useless advice to most investors. Even in a bull market, there are individual stocks that are undervalued; even in a bear market, there are individual stocks that are overvalued. If you want to know if stocks, on average, are overvalued, you need to choose your measuring stick. The most commonly used is the price-to-earnings ratio, abreviated P/E or PE. Generally, low PEs are better, as they indicate more earnings you get for each dollar you spend on a stock.

But PEs don't exist in isolation, whether you are looking at market averages or a PE for an individual stock. Two companies can have stocks that are at differing PEs, but both be of equal intrinsic value. For instance, company A might seem like a twin of company B except that A has a healthy cash balance and B is deeply in debt. So even though they both produce the same earnings (aka net income), we would expect A to be more highly valued, and it would have the higher PE. That does not mean company B is bad, it just takes the debt into account when valuing the stock.

Companies C and D might also be twins, if you just look at their accounting numbers for the latest quarter. But company C is a technology innovator and is growing its revenues and profits, while company D is essentially static. So company C should have a higher PE. If it did not, investors who owned D and looked at C would sell D and buy C until an equilibrium is reached.

There are, of course, other variables that affect a company's PE, including subjective factors.

Now think of stocks in general, or in aggregate. It does not make sense to say something like "between 1932 and 2009 the average stock PE was X" but today the average stock PE is X+ something, so stocks are too high.

To value stocks in general, you would need to know how much cash and debt there is on the balance books of the companies we are aggregating. You need to know whether the bundle of companies is growing revenues and profits. You need to know where you are in an economic cycle, which no one seems to be very sure of. You would need to predict the rate of inflation, and compare stocks to alternative investments like real estate, bonds, cash, and CDs.

You also need to look at how the PE itself is created. I like GAAP numbers because they take everything into account, but someone trying to sell you stock almost always uses prettier non-GAAP numbers. The stated PE is usually reasonably objective (once you choose between GAAP and non-GAAP) because it is based on published reports for the last four quarters. But where the company will be in a year is important to investors, and that is guesswork.

What if PEs for the market at a whole are above some historical average, but in six months, if prices remain the same, they will be below the historical average because profits are ramping?

Profits were horrible in Q1 and Q2 2009. Do we measure a company's worth by its profits in those quarters, or by a backward-looking year that includes those quarters? Certainly we should take those quarters into account, but they should not be allowed too much bias.

In this market, where people feel they were lied to in the last bull market (because they were) and are struggling just to keep their homes, only a few stocks are likely to be truly overvalued at any time. From my point of view hundreds, if not thousands, of stocks are so undervalued that I wish I could buy them all. I would buy the whole companies at today's prices, if I were in that league of investor.

Instead I manage my small portfolio as best I can. It includes some speculative stocks of companies that will leap in value if they can ever get to profitability, like Hansen Medical and Dot Hill. But the core of my holdings are in companies like Marvell Technology Group, Gilead, and Biogen. They have large cash balances, are growing, and yet have low PEs. There are hundreds of stocks that have all these attributes right now. And there are good companies paying higher dividends on their stocks than you can get from CDs or Treasury bonds.

Know what you are doing. Do your own research. And ...

Keep Diversified!