The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (17 page)

Many people will have different views of historical P/Es, just as they have different views of historical homes prices. However, we think Dr. Shiller has done the best job at giving us a good idea of what historical P/Es have been.

Although P/Es are the most common method for valuing stocks, there are other methods for valuing a company that currently doesn’t have earnings but could have in the future, or whose assets have value beyond their earnings (possibly due to mismanagement of the company’s assets). We should also say that there are a multitude of methods used to value companies, some of which are proprietary and many of which are much more complex than those discussed in this book. What we are trying to give you is a basic overview of how stocks are valued, as a background to understand conventional wisdom and why it is wrong, not a course in equity valuation and analysis.

Price-to-revenue ratio
. If a company doesn’t have earnings due to mismanagement or an economic downturn, or for a variety of reasons the company’s earnings are not a good measure of the company’s future or potential health, a different measure of value could be used, which is the price-to-revenue ratio. In this valuation method the investor simply looks at the price of the stock relative to its revenues to determine its value. The clear risk in this analysis is that by ignoring earnings you could be getting yourself into an investment that ultimately doesn’t pay off. Even very large companies and investors have made big mistakes relying on such analysis to make investments. It is also much easier to get a bubble valuation when you ignore earnings.

Book value or liquidation value
. Sometimes a company mismanages its assets. Maybe it’s an older retail chain that isn’t very good at retailing anymore but owns a lot of good retail real estate. Maybe it’s an oil company that is not well managed and is just riding on the earnings from oil and gas wells drilled many years ago. In this case, valuing the company at its liquidation value makes sense. A liquidation value is the value of the company’s assets, not its earnings or revenues. This may help an investor see what may be the hidden value in a mismanaged company. A comparison of the company’s stock price to its liquidation or “book value” is also one way to measure how the market views the quality of a company’s management and its assets. Currently, many large banks are valued below book value, indicating that many investors think the bank is overvaluing its assets and is possibly managing what assets it has very poorly.

Private-company valuation
. Private companies are usually valued at a significant discount to public companies. This is largely because they are less liquid (harder to sell) than public companies. You can sell a share of public company stock very easily. Not so with a private company. This is often referred to as the marketability or liquidity discount. However, today a big part of the reason that private companies are valued significantly less is that they are not participating in the public stock market bubble.

As a comparison to public companies, private-company valuations don’t usually vary that much over time, unless they happen to be in a hot industry, such as social media. In fact, they usually trade for about 4 to 6 times earnings. That means that private buyers are willing to pay about 4 to 6 years of profits to buy a company. That actually makes sense given all the uncertainties in any company’s future earnings. But notice how much lower that is than public company stocks, which often have valuations of 15 to 20 times annual earnings. A normal marketability discount might be 20 to 30 percent. But the actual discount for being private is much higher, which is a partial indication of a bubble stock market.

In addition, many private companies are bought with borrowed money based on paying back that loan from the company’s earnings. Hence, many people buying a company don’t want to buy a company that will take more than four to six years to pay off its loans. They don’t plan to flip the company. They plan to make money from it, and they want to make money from it as soon as possible. This type of valuation makes a lot more fundamental sense than a bubble valuation. It is also similar to the leveraged buyout (LBO) valuation model used in Aftershock wisdom, which we will describe later in this chapter.

No discussion about stock valuation would be complete without some mention of the bible of stock valuation, Benjamin Graham’s classic book
Security Analysis
. Published in 1934, this landmark book on stock valuation is what Warren Buffett most often refers to when speaking about his own views on company valuation. Graham’s book offers investors three guiding principles. First, always invest with a margin of safety by buying at a discount to a stock’s “intrinsic value.” That way, if the market value falls a bit, you are still ahead. Second, expect market volatility and find ways to profit from it. Options for doing this include dollar-cost averaging and diversification. And, third, know your investing style: actively involved and willing to research and learn on your own over time or more passively involved and in need of professional assistance and lower risk.

The overriding mantra of the recent stock market CW cheerleader is that stocks are always poised for growth, while gold is at its peak and ready for a fall. Never mind that since 2000 exactly the opposite has been true. The goal of the stock market cheerleader is to
sell stocks
, not to do proper historical analysis. Of course, as we always say, CW faith in more growth ahead is grounded in history—at least the part of history they like best (i.e., the rising bubbles). CW says the future will be like the good past. Yes, the CW cheerleader would agree that the recent past has not been kind to stocks, but if you look farther back in history, the performance in stocks has been quite good. On this, the cheerleader is correct. Just like real estate, stocks have been a good buy over the long term, especially if we define the long term as since 1950. If we ignore the Great Depression and the long, slow recovery of the market during World War II, stocks look pretty good historically.

If you look at the Warren Buffett chart on stocks since 1965 that we presented in Chapter 3, it looks even better. So if the future is like the past, especially those golden years of 1980 to 2000, when the stock market was up over 1,000 percent, the future is pretty bright. It’s also easier to overlook the past 10 years and assume that this is more like the 1970s—just a prelude to another stock market explosion of 1,000 percent or more.

However, none of this analysis looks at the fundamentals. In fact, it really isn’t even analysis. It’s just saying that the good part of the past will inevitably continue and the bad part will inevitably give way to the good part. As we said in Chapter 3, there are fundamental economic reasons why the future will be different from the past, especially the good parts of the past. Actually, if you go back over the past 200 years of financial and economic history, it’s easy to see that big change is the real pattern of financial history—not just endless and enormous growth in the stock market as far as the eye can see.

That type of analysis is not analysis, it’s just salesmanship. And even hard-nosed stock market analysts are primarily employed by firms that all started as stock and bond sales firms and which to this day are heavily driven by the sales of various stock- and bond-related securities. So it’s no surprise that when the financial analysts employed by these firms are asked to rate stocks, they usually rate them as a buy or a hold. In fact, research on analysts’ opinions shows that they rate stocks as buy or holds over 95 percent of the time, as indicated in
Figure 4.2
.

Figure 4.2
Stock Analysts’ Buy/Sell Recommendations, November 2011

Very few analysts recommend selling stocks. Mostly they suggest buying or holding.

Source
: Fact Set Research Systems.

This seems a whole lot less like analysis and a whole lot more like salesmanship. And that salesmanship mentality pervades Wall Street and the financial press. In one way or another, the livelihoods of all these people often depend, in one way or another, on good sales of stocks and bonds. We’re not trying to be critical—it’s just the truth. Everybody has to make money. But that means it’s not the best environment for hard-nosed and objective analysis. Ask someone who knows and has tried to do objective analysis, like Mike Mayo, who recently wrote
Exile on Wall Street
(see sidebar) about his work analyzing the banking industry. The financial press doesn’t always like someone who challenges the prevailing CW on Wall Street and neither does Wall Street.

Many financial analysts would say in protest that they are doing proper analysis and not cheerleading. They are applying the valuation methods just discussed in one form or another and those methods, although improved, haven’t fundamentally changed during the stock market bubble. That’s true, but as we pointed out in that discussion, assumptions of future economic conditions and company earnings are absolutely fundamental to that analysis. And the current analysis depends on two key assumptions, which we discussed in Chapter 3: (1) the assumption of a natural growth rate and (2) the assumption that we are not in a multibubble economy.