How NOT to Value a Stock: 4 Stock Valuation Mistakes To Avoid
Valuing stocks is a tricky business, while trying to predict stock movements over time is near impossible. Perhaps because of the difficulty of valuing stocks, many self-proclaimed traders start looking for patterns and rules of thumb to help them choose which stocks to buy. One of the troubles with the stock market is that a monkey picking stocks at random tends to do just as well as professional traders and stock pickers. So what does that mean for you if you are just getting into investing? It means that you may think a strategy is working well when in actuality you are getting lucky!
Getting lucky multiple times in a row can lead you down the path to despair. It’s tough not to attribute success to superior trading ability; however, if you let hubris take over you may find that logic has been completely thrown out the window. Here are 4 valuation mistakes you should avoid when investing in individual stocks.
1. Avoid historically valuing stocks
Have you ever heard someone say something like “the stock was trading at $50 four weeks ago and now it’s trading at $30 so it’s a real bargain!” Do you think that person stopped for a second and thought about how the stock may have been really expensive at $50 and now it’s just fairly priced? Or perhaps something changed in the long term fundamental outlook for the stock. Let’s assume that this person has done a bit of homework and found out that there was a reason for the drop in the stock, but they think the stock dropped too far. If they didn’t have a fundamental idea of what the stock’s value was before it dropped and they have not revalued the stock, how could they know if the stock dropped too much or too little? If you don’t have a target value for a stock based on fundamentals or relative value, then you have no business making statements about how much a stock should change in value when fundamentals change.
2. Avoid trading based on value advice you see on TV or in a newspaper or magazine
People are quick to give stock advice in the media; however, they rarely give a full account of why they think a stock is a buy or a sell. If you don’t know how they came to their conclusion, you can’t be sure whether they themselves are falling victim to the same major valuation mistakes you are trying to avoid. The bottom line is that you need to have a full understanding of the value of a stock and how that value was derived in order to make an investment decision.
3. Avoid relative valuation using only ratios when valuing stocks
P/E ratios, to give just one widely used valuation ratio, are a deceivingly simple way to compare the valuation of similar stocks. Using any sort of ratio alone to value stocks will give you an incomplete view of the fundamentals that are driving that value. For example, the fundamental drivers of the P/E ratio in a stable company are growth, the cost of equity, the dividend payout ratio, and indirectly return on equity (ROE). In a growth company the dividend payout ratio would be replaced with free cash flow to equity (FCFE)/earnings.
Holding all else equal, higher growth, higher ROE, a higher payout ratio (higher FCFE/earnings), and lower cost of equity will increase a company’s P/E. For example, two companies could have the same P/E but one could be a much better value if it had higher expected growth or a lower cost of equity. If you are going to use relative valuation to value stocks you need to make sure you also compare expected growth, ROE, payout ratios, and costs of equity. If you don’t understand the reasons why the P/E for a stock is higher/lower than another stock then you don’t actually have a basis for your relative comparison.
4. Avoid valuing stocks based on observations you have made about products, companies and management
If you base buy and sell decisions solely on observations you make about companies without understanding the current value of the company’s stock, you will have no idea what amount of growth, good management, and great products are already priced in. This can lead you to buy great companies that are overvalued and/or sell bad companies that are undervalued. It’s common to hear people say they have made lots of money investing in companies they believed in; however, if you buy a company without knowing what future growth rate is already priced into the stock, you may be paying too much.
One of the most difficult things to do in the stock market is to distill a stock pickers performance into what part was luck and what part was actually skill. If you insist on picking your own stocks, make sure that you are doing enough fundamental analysis to at least be able to break down what future assumptions are priced into the value of the stock you are buying. If you don’t want to spend the time gaining the skills and knowledge necessary to value stocks, you would be much better off investing in a diversified portfolio of index mutual funds and/or ETFs.