| Topic - Stock Price Valuation: It's All Relative | Education Center |
IT'S OFTEN SAID that a raging bull market can make any investor look smart. But one of the more tragicomic aspects of the '90s bull run has been how it's made so many highly educated market watchers look — can we say it? — dumb.
Take Michael Metz, the former stock-market strategist for Oppenheimer & Co. Long one of the most quoted pundits on Wall Street, Metz's valuation models began to fail him in the mid-1990s when they started spitting out Sell signals just as stocks really began to take off.
"Frankly, I think it's exit time," he said in May 1995, only to watch the Dow jump 15% over the next six months. As the index doubled within three years, it wasn't long before "former" became a permanent part of his title.
Metz was hardly alone. In 1996, no lesser light than Federal Reserve Chairman Alan Greenspan put the market in a temporary tailspin when he suggested in congressional testimony that stocks were suffering a bout of "irrational exuberance." Over the next two-and-a-half years, the S&P 500 grew 84% as it charged to one new record after another.
The lesson here is that stock valuation is almost always a moving target — so much so that even the most experienced investors can get flummoxed by it. There's little argument that the best way to predict future movements in stocks is to assume that — all things being equal — they'll pretty much do what they've done in the past. But since all things rarely are equal, you can leave all hard-and-fast formulas at the door.
Your best defense is to look at a stock's value relative to as many benchmarks as you can find. And when the bedrock shifts, your assumptions must shift along with it. As we'll see later in this piece, Metz, Greenspan and many others were taken by surprise in the late 1990s when the economy failed to behave as it normally does. What the pundits didn't see — not right away, at least — was that when productivity soared and inflation disappeared, the tide supporting stock prices began to rise. Companies that looked expensive by traditional standards weren't so pricey after all.
(Before you go on, if you lack an understanding of the basic principles underlying stock valuation, you should start with our primer How Much Is This Stock Worth? It will make what follows much more useful.)
The Theory of Relativity
OK, so how do you develop a strategy that won't suffer blind spots? The first thing to do is get your bearings by comparing
a company's current valuation to:
(We're using the word valuation here to mean any measure of a stock's value. Price-to-earnings is by no means the only ratio available to you and isn't even the most reliable in all cases. We'll introduce many others in Digging Into the Numbers.)
In January 1995, for example, Bristol-Myers Squibb traded at a split-adjusted price of 22 1/8, giving it a P/E of 13.4. Was it cheap? Sure looked that way. Historically, the drug company had traded at a P/E of approximately 17, so investors clearly weren't paying as much for the stock as usual. Meanwhile, the average pharmaceutical stock was trading at a multiple of around 21.7 (just a hair below the historical average of 21.8), and the S&P 500 index was averaging 15.3.
Based on the historical relationship between Bristol-Myers Squibb and the drug industry, it was a pretty good bet that the company was undervalued. And boy was it. Had you bought the stock in early 1995, you would have tripled your money over the next four years.
But that's an easy example. As Metz might tell you, historical relationships aren't always enough. Valuation ultimately comes down to a company's earning potential. And if something has changed to alter that, historical relationships can change, too — sometimes drastically.
The Bigger Picture
Here are four questions to ask yourself when examining companies that have strayed from their historical valuations:
Consider the case of Amgen — a lightning rod for attention during the biotechnology craze of the late '80s and early '90s. The company built a record of tremendous growth on the success of a couple of products that helped anemics and cancer patients produce blood cells. In the two years between January 1990 and January 1992, the share price rose more than 800%. Amgen's multiple averaged a lofty 62 times earnings.
But in the winter of 1993, Amgen stumbled. Sales of its flagship Neupogen product dipped and analysts slashed earnings expectations. Angry investors, who felt that the company had lost its edge, drove the stock down more than 40%. By early spring the P/E had dropped to 17 and earnings-growth projections shrank from triple-digit levels to something more like 20%.
Was the party over? Quite the contrary. Though Amgen's average P/E from February 1993 to May 1999 was 23.8, its stock soared by 500% as earnings settled into a more sustainable growth pattern. What had shifted downward — permanently — was the amount investors were willing to pay for that earnings growth. Those searching for value in the later years had to bear that in mind.
Opportunity, of course, can also improve — even for an old-line sector like banking. Because they have historically derived so much of their income from lending money — a highly cyclical business — banks have traditionally traded at a 40% discount to the S&P 500. But in the mid-1990s, when the government loosened restraints on the types of businesses banks could get into, they began to buy brokerages and other sorts of financial-services companies and increased their level of fee income, a much more steady supply of profits. The best banks — powerful outfits like Citicorp and Wells Fargo — began to command higher average multiples. Were they overvalued? No — their business had made a long-term change for the better.
Whither Interest Rates?
And that brings us to what so confused market watchers as the '90s bull market ran forward. If you look at just the stock
chart of just about any healthy company during the latter half of the decade, you'll see a gradual creep into uncharted
valuation territory. Between January 1995 and January 1999, the average P/E for the S&P 500 index doubled from 15 to
almost 30 and for many investors with a value orientation it became difficult to justify buying just about anything but the
market's dogs.
Markets, of course, have their own cycles. And when the average P/E gets that high, it often ends in a crash. Shadows of Black Tuesday in 1929 and Black Monday in 1987 still hang over Wall Street. As stocks started to move toward unprecedented valuation ranges, pundits like Metz and Morgan Stanley's Barton Biggs began decrying the market as dangerously overvalued.
Why were they so wrong? Their models failed to take into account some key changes in the market's fundamentals — most notably that the 1990s ushered in an unusual mix of low inflation and strong economic growth. The combination worked to keep long-term interest rates low and corporate profits steady — both important buttresses to stock prices.
Valuation begins with a question: If I put my money into this company, what are the chances I'll get a better return than if I invested in something else? It's a matter of risk vs. reward. The safest investment is a U.S. Treasury bond because its return is guaranteed by the "full faith and credit" of the federal government. A stock's value proposition starts there — how much more will it return than a Treasury bond and at what risk?
Lower interest rates mean lower bond returns. So it follows that lower rates make stocks that much more attractive. Who wants to invest in bonds with low interest rates? Most people would rather pay more for stocks and the possibility of much higher earnings and earnings growth. As money leaves the bond market and heads for the equity markets, the average stock price rises and P/Es go up.
With inflation at bay during the 1990s, there was no particular reason to raise interest rates, so they stayed at all-time lows. The result was more support for higher multiples. Of course, not all parts of the stock market are affected equally by the trade-off between stocks and bonds. Most bond investors like the security, so they gravitate toward stable, large-cap stocks. That means small caps can be relatively undervalued to the market at the same time they are at the high end of their own historical range.
As you can see, deciding whether a company is trading below its potential is as much of an art as a science. The important thing, however, is to remember that valuation is a moving target, making it all the more crucial that you evaluate a stock both within its own context and in the context of the market in general. The next section will give you some tools to help in your search.