Price to earnings ratio or the PE ratio is the first thing you’d look at to figure out if you are getting a good deal on a stock. For example, a PE ratio of 20 implies that for every dollar in profits the business behind that stock makes, the stock is priced at 20 times that.
To get a better feel for a stock’s value, you can flip that PE ratio around. That gives us the earnings yield for a stock.
So a stock with a PE ratio of 20 means its earnings yield is 5% (E/P = 1/20 = 0.05). You can then compare that yield to say the yield you get from a bank savings account to decide which one is a better deal. Not a perfect comparison but you get the gist.
But you know it is not that simple because sometimes you see stocks trading at PE ratios of a hundred or a thousand. Stocks of some companies that don’t make profits yet don’t even have PE ratios. So no earnings yield to compare to.
And sometimes, the price of a stock rises way too high and way too fast due to rapidly rising profits. The market then is constantly having to reprice the stock to reflect its true value.
But what if those profits are transitory? If and when those profits normalize (fall), the price of that stock could crash back down to earth.
In both scenarios though, it is impossible to know if there is a price bubble or not because of how a stock’s value is derived.
And the market tries to price the stock as close to its true value as possible but it does sometimes fail because of how incredibly difficult the task is. You then mix human beings in the game with all their hopes and worries and fear and greed and that task gets doubly difficult.
So ignoring for the book value in the stock value equation above, stocks as should be known are long duration assets. They are in fact perpetuities with cash flows (dividends) expected to go on forever. That is what the three dots at the end signify.
And think of book value as the total value of all the infrastructure a business needs to run its business. Think buildings, factories, machinery etc. But with some of the biggest businesses these days not needing much infrastructure, ignoring for the book value is a decent assumption.
Back to the stock value math, D is this year’s dividend. Many stocks don’t pay dividends but ultimately, all stocks must return all the accumulated profits they earned in their lifetime as cash dividends. So when a stock that doesn’t pay dividends yet, will start to pay dividends and how long will it continue paying those dividends becomes a big unknown for many stocks.
r is the growth rate of those dividends. This is one reason you cannot compare investing in stocks to say investing in a bank savings account because the cash yield with stocks (dividends plus the growth rate of those dividends divided by the stock price) keeps on changing but the yield with a bank account remains fixed.
And where does the growth in dividends come from? It comes from a business taking its profits, using some of it to pay cash dividends and reinvesting what remains back into the business.
And businesses usually don’t do dumb things with their money (your money). Their goal is to maximize shareholder wealth. They do that by investing in projects that earn more than what they can earn investing in safe investments like Treasury bonds.
And not just that, they must invest in a way that overcomes the amount of risk they take investing in a given project. That risk depends upon a business’s past history investing in similar projects as well as that business’s overall financial strength. Google can afford to fail at projects they invest in and still continue as a going concern but a small startup may not survive if their projects fail.
i is the discount rate used to bring future dividends to the present. You have to bring future dividends to the present to assess the value of a stock in today’s dollars because the price you are comparing it against is today’s stock price.
And think of the discount rate as a combination of two things. The first is the baseline rate a business reinvesting back into its business must earn. Most projects a business invests in take years to bear fruits with 10 years being a typical timeframe. That tells you that you don’t invest in stocks unless you have a 10-year minimum time horizon.
A comparable duration baseline investment to stocks then is the 10-year Treasury bond. It is the benchmark interest rate that guides all investing decisions, literally all over the world.
So any investment a business makes must earn more than what a Treasury bond yields. And that bond yield in turn depends on inflation. If inflation is high, the Treasury bond’s yield will also be high.
And as discussed before, the second thing that makes up the discount rate is the risk level of a business. The market assigns a certain risk premium (equity risk premium) to a business over the baseline Treasury bond rate. Google being financially more stable is assigned a smaller risk premium than a software startup.
And since discount rate is in the denominator in the stock value equation, a business needing a smaller equity risk premium is valued more than the one needing a larger one.
One more quick glance at the stock value equation and you notice that the dividend growth rate is in the numerator and the discount rate is in the denominator. Both these numbers need to be known to derive a value for a stock. The discount rate has inflation built into it through the baseline Treasury bond rates. The discount rate also has the risk level of a business built into it. All these numbers need to be known, year in and year out into perpetuity to get a stock’s value right.
That is asking for God-level foresight. The stock market though, through its millions of participants, duke it out each day to arrive at a fair price for a business. That stock price on your phone screen is not just some arbitrary number. It has a lot of information built into it.
So when do you make a lot of money owning stocks than what’s already priced in?
- A big factor that is tied to business profits is when the dividend growth rate surpasses what the market was expecting.
- And/or when inflation comes out to be lower than what was expected. Since inflation impacts Treasury bond yields and Treasury bond yields impact the discount rate, the lower the inflation, the lower the discount rate and higher a stock’s value.
- And/or when the risk profile of a business changes from high risk to moderate risk to low risk. That again reduces the discount rate and with it being in the denominator of the stock’s value equation, the value of a stock rises bigly which should then get reflected in its price.
So what’s the remedy to protecting your money against a bubble-type backdrop? The first is time. You just have to wait out the damage a bubble bursting may cause. Because you also don’t want to miss out on the upside in case a perceived bubble may not be real. That is where good asset-liability matching helps. You adjust the duration of your investments to match the timeframe on when you’ll need the money while letting the remaining ride.
You also diversify judiciously, especially if you find yourself overly exposed to the bubble sectors. You got lucky. Use that luck to lock in your goals.
Thank you for your time.
Cover image credit – Valeria Danilova, Pexels