The three key evaluations that an investor should make are those of the economics of the business, the quality of the management and the valuation of the shares. There are lots of good businesses with good management but this is generally reflected in the price; it is rare that you will find these at a bargain price.
The theoretical basis of valuation is simple – it is the discounted present value of all future cash flows (dividends, payments for rights, returns of capital, etc) at the time of valuation. This is commonly known as the dividend discount model. (The future share price is irrelevant because when a shareholder sells the share, the price should be the discounted value of future cash flows at the time of sale.) But the application of this basis is impractical because future cash flows for shares, unlike gilts, cannot be forecast with sufficient accuracy and because even small changes to the discount rate, which is necessarily subjective and not a constant, result in huge differences in the resulting value.
The dividend growth model is derived mathematically from the dividend discount model and is therefore theoretically sound. Basically it says that the price should be the expected dividend divided by the difference between the expected return and growth rates. Or, rearranging the terms of the equation, the return will equal the present dividend yield + growth rate of dividends. This is a useful concept for making a quick calculation of the expected return if investing in a company that has a yield and where the dividends are expected to grow at a constant rate forever. Dividends do not, in fact, grow at a constant rate forever but it is nevertheless a useful rough and quick method of estimating expected return for some companies.
Various methods of valuation are used such as abnormal earnings valuation (including economic value added), price / cash flow, return on equity / capital employed, etc. All these methods suffer from the fundamental limitation of the quality of the data from which they are calculated.
The price/earnings ratio (PER) is the most widely used method for determining whether shares are “correctly” valued in relation to one another. But the PER does not in itself indicate whether the share is a bargain. The PER depends on the market’s perception of the risk and future growth in earnings. A company with a low PER indicates that the market perceives it as higher risk or lower growth or both as compared to a company with a higher PER. The PER of a listed company’s share is the result of the collective perception of the market as to how risky the company is and what its earnings growth prospects are in relation to that of other companies. Investors use the PER to compare their own perception of the risk and growth of a company against the market’s collective perception of the risk and growth as reflected in the current PER. If the investor feels that his perception is superior to that of the market, he can make the decision to buy or sell accordingly.
In practice, all valuation is relative – not only in respect of shares relative to other shares but also as between different asset classes such as shares relative to gilts. So for example, the PER of GlaxoSmithKline will be relative to that of Astra Zeneca taking into account the risks and growth prospects of each. Or the expected return from shares may be compared to that from gilts – the return from gilts can be predicted with certainty if held to maturity so that there is no risk of deviation from the expected return as in the case of shares but then the earnings/dividends from shares are expected to grow while the interest from gilts will remain constant and the relative valuations will reflect these considerations. The obvious limitation of using relative valuations is that all the valuations may be too high or too low. Thus, in a bubble, relative valuations may be reasonable but, when the bubble bursts, all the shares will be marked down. So the investor also has to make a judgement as to whether the market as a whole is under or over valued.
A totally different approach to valuation is that per Keynes. Richard Barker describes this in his excellent book "Determining Value" from which I quote selectively below:
Perhaps the best-known and most insightful analysis of the speculative determination of stock market prices can be found in Keynes' General Theory (Keynes, 1936, Chapter 12). Keynes identifies two features of the stock market that lead to speculative behaviour. The first of these is the uncertainty of the future. "Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible..."
... Keynes identifies liquidity as the second feature of stock markets that induces speculation. "In the absence of security markets, there is no object in frequently attempting to revalue an investment to which we are committed. But the Stock Exchange revalues many investments every day and the revaluations give a frequent opportunity to the individual ... to revise his commitments. It is as though a farmer, having tapped his barometer after breakfast, could decide to move his capital from the farming business ... and reconsider whether he should return to it later in the week."
In Keynes' analysis, the two factors uncertainty and liquidity combine to generate speculative bubbles. The importance of the first factor, uncertainty, lies in its influence on investors' perceptions of current stock market valuations. Investors develop what Keynes calls 'conventions', meaning commonly accepted beliefs about the uncertain future... In effect of course, these conventions are myths, because we cannot have certain knowledge about the future.
"... [Professional investors] are, in fact, largely concerned, not with making superior long term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead [of others] ... For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence."
Novice investors are often under the delusion that there is a method of calculating the precise value for a share and spend time trying to discover this method. They are no more likely to discover it than the alchemists who tried to discover how to turn base metal into gold. In practise, it is sufficient to form a judgement as to whether a share is significantly under or over valued.
Some quotes from big names in investment about the importance of valuation:
Benjamin Graham
If forced to distil the secret of sound investment into three words, they would be: margin of safety.
The really dreadful losses ... were realized in those common-stock issues where the buyer forgot to ask "How much?"
... stocks with good records and apparently good prospects sell at correspondingly high prices. The investor may be right in his judgement of their prospects and still not fare particularly well, merely because he has paid in full (and perhaps overpaid) for the expected prosperity.
Peter Bernstein
No amount of study in this area can minimise the importance of trying to buy at a fair price; buying at any price and hoping that the future will take care of itself is a good shortcut to disappointing results.
Mario Gabelli
Mr Market gives you opportunities to buy shares above and below intrinsic value. So risk can come in because you’re buying a great franchise, a great business, run by wonderful people, but at too high a price.
Mark Mobius
A truly great business that can grow many times its current size is not often available at a low price-to-earnings (P/E) ratio.
Burton Malkiel
The firm foundation theory relies on some tricky forecasts of the extent and duration of future growth.
Depending on what guesses you make, you can convince yourself to pay any price you want to for a stock.
Over shorter periods, changes in the price-dividend or price-earnings multiple is critical in determining returns.
Unsustainable prices may persist for years, but eventually they reverse themselves. Such reversals come with the suddenness of an earthquake; and the bigger the binge, the greater the resulting hangover.
Never pay more for a stock than its firm foundation of value.
Dividend increases are usually an accurate indicator of increases in future earnings.
I have a good friend who once built a modest stake into a small fortune. Then along came a stock called Alphanumeric. I begged him to investigate first whether the huge future earnings that were already reflected in the share price could possibly be achieved given the likely size of the market. He thanked me for the advice but dismissed it by saying that stock prices weren’t based on “fundamentals” like earnings and dividends. “They are based on hopes and dreams” he said. And so my friend had to rush in before greater fools would tread. And rush in he did, buying at $80, which was close to the peak of a craze in that particular stock. The stock plunged to $2, and with it my friend’s fortune. The ability to avoid such horrendous mistakes is probably the most important factor in preserving one’s capital and allowing it to grow.
Stock prices are anchored to ‘fundamentals’ but the anchor is easily pulled up and then dropped in another place. Given that expected growth rates and the price the market is willing to pay for growth can change rapidly on the basis of market psychology, the concept of a firm intrinsic value for shares must be an elusive will-o-the-wisp.’
Warren Buffett
It is better to be approximately right than precisely wrong.
You do not have to know the exact weight of a person to know that he is fat.
Investors making purchases in an overheated market need to recognize that it may take an extended period for the value of even an outstanding company to catch up with the price they paid.
This kind of uncertainty [where it is not possible to be certain with any degree of certainty of the outcome] frequently occurs when new businesses and rapidly changing businesses are under examination. In cases of this sort, any capital commitment must be labeled speculative.
The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money.
... we make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises. We're not smart enough to do that and we know it. Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners. Even so, we make many mistakes.
Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices.
...businesses selling at low multiples of earnings. These, of course, were characteristically mediocre businesses with poor long-term prospects.
You can turn any investment into a bad deal by paying too much. What you can’t do is turn something into a good deal by paying little.
Investors should be sceptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulae.
Be fearful when others are greedy and greedy when others are fearful.
See also the topic on bubbles.