Value Is in the Eye of the Beholder

I started in the financial publishing industry as a “temp” back in 2011. I spent my first week learning about the industry, and the writing style and routine of my assigned senior editor—the income guy. During that week, he handed me a copy of Benjamin Graham’s The Intelligent Investor.

If you’re not familiar, he’s considered the father of value investing. And he’s credited with popularizing fundamental security analysis by laying out how to study financial statements to determine what a business is actually worth.

This is opposed to the price set by Mr. Market, a “guy” who shows up every day offering to buy or sell your shares. Some days he’s greedy and some days he’s fearful. And that mood influences whether prices are rising or falling.

A share of stock represents ownership in a very small piece of a business. At any point in time that share has two values: the one the market has assigned to it, and the result of dividing the value of the business by the number of outstanding shares. Graham thought we should only act when Mr. Market’s mood is clearly in our favor.

As the S&P 500 rips to new highs, it’s more important than ever to make sure that you’re not overpaying for shares.

A Few Ways to Look at the Math

The most common metric used for valuation insight is the price-to-earnings or P/E ratio. This tells us how much investors are willing to pay for $1 of a company’s earnings. Here’s the math:

Graham believed you shouldn’t pay more than 15 times earnings for shares of a business. Modern markets generally have much higher valuations. For example, the current forward P/E ratio of the S&P 500 is 20.9, above its 5- and 10-year averages of 19.9 and 18.9.

Another price multiple used for valuation insight is the price-to-book or P/B ratio. This tells us how much investors are willing to pay in relation to a company’s book value, or its net asset value on a per share basis.  Here’s the math:

This method is useful for asset-heavy industries, but can be less relevant for technology or service companies. Graham’s target here was 1.5. The S&P 500 is currently trading around 5.5 times book value. This is a clear sign to me that the overall market is overvalued and you are very likely to overpay for shares right now.

But We’re Not Value Investors

Graham actually took these two value gauges one step further. He used a combination of the two metrics to calculate the maximum that one should pay for a stock.

Since the formula uses P/B it is best suited for mature companies with strong assets and not high-growth or tech companies, which make up a large part of our markets today.

It also uses the original targets of 15 (P/E) and 1.5 (P/B), which are hard to apply in current markets. The resulting target price would never let you add any shares. Nevertheless, these numbers are still useful.

I don’t use these valuation metrics as a hard-and-fast rule. I like to use them as a comparison tool. Most stock screeners will let you search or sort by both P/E and P/B. I like to look for dividend payers that are trading “cheaper” than the overall stock market or its sector peers. We don’t chase share prices, but I still want to get a good deal.

Our dividend yield—aka how hard our money is working for us—is inversely related to the share price. The lower our entry price, the higher our yield will be. If we overpay, our yields plummet.

Believe me, I want to get caught up in the optimism of the overall market with everyone else. My experience in the market reminds me this is a surefire way to buy high and sell low. As we navigate through the current earnings season, look for the undervalued and come back to the math instead of getting swept up in the sentiment.

For more income, now and in the future,

Kelly Green