With the stock market bubbling to new highs, investors are right to be skittish. While corporate profits are still growing, so are corporate valuations, which have never been higher. That raises the obvious question of whether now is a good time to be investing in the market. When you invest in stocks, you’re investing in corporate profits, which are abundant these days. But with surging valuations, how much are you paying for those profits? If you overpay for a stock, you may cap your upside while leaving your downside completely exposed.
I contend that there is still a lot more upside in this market but not without some bumps along the way. I would also agree that many stocks are fully, if not overvalued. If you can avoid those stocks, your ride will be less bumpy. While the stock market as a whole looks very expensive right now, there are still plenty of companies—well-managed and well-positioned for growth—that are not fully or even fairly valued that present good opportunities for investors. The key is knowing where to look and how to parse the data to reveal their potential.
Using Multiples to Value Stocks
When valuing stocks, we use at least four methods to determine whether a stock is priced right. I can’t go into detail about all of them but in the space allowed here. But as a starting point, I can share how we screen stocks based on their multiples. With multiples, you can eliminate a lot of the chaff to get to the wheat.
The most common multiple used to see if a stock is priced right is the earnings multiple or Price-to-Earnings (PE) multiple. A company’s PE ratio tells you that the price you pay is some factor more than what you are immediately getting. For example, if a company generates a dollar per share in earnings, the PE multiple expresses what you should expect to earn if you own the stock into the future. That is how the market values the stock.
Multiples Must be Viewed in Relative Context
However, looking at a company’s PE multiple alone doesn’t provide the context needed to determine whether the stock is currently priced right. If a company’s PE multiple is 15 times earnings but has traded at an average multiple of ten times earnings over the last ten years, it is trading at one and half times its historical average. Looking at a company’s PE history can give you a sense of how the market has valued the company over time.
As an investor, you would want to avoid investing in a company with a current multiple that is higher than its historical average. If you pay above the average multiple, there’s a 50% chance that, when you sell the stock in the future, you will sell it a lower multiple than it is currently selling.
Conversely, if you buy a stock at a price that reflects a multiple less than its average, your chances of selling it in the future at the average multiple or higher are greater than 50%. You can build in a margin of safety that can reduce your downside risk by buying the stock at a discount to that average. In other words, if the historical average multiple is 10, we would wait for a one-third discount to that average and buy it at a multiple of around seven. That means there is a much better chance of selling that stock at a higher multiple in the future.
Understanding the historical valuations of a company over time allows us to draw some conclusions, but we need more context. A stock could look expensive relative to its history, but it might be selling at a deep discount relative to its peers. So, we do a comparative analysis to see how a company’s PE stacks up against its peers, including its direct competitors and related businesses in the industry. If a company’s PE is below the average of its competitors, it could indicate that the stock is selling at a discount.
Investors who perform this kind of analysis might find that, even if the stock market appears very expensive, they can still find individual companies selling at a discount. From there, you can conduct additional fundamental analysis to determine if all the business drivers are in place to propel the company’s growth well into the future.