How to evaluate values

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Most people want to create increased personal wealth.

The income received from employment is the primary source of funding for the majority.

However, when part of this can be saved and invested, its subsequent growth means having someone working for you to create profits; it’s effort free and wonderful!

Money working on its own to make more money and the investor growing wealthier; what’s not to love about that?

This is essentially the world model of how people with excess assets over liabilities become increasingly better off over time and why the disparity between this class and the majority who live at the limit or below their earning capacity is ever widening.

But the above scenario comes with a major question for those with excess capital.

They say:

“I have money and I want my money to make more money, I like it when it does that.
But what I don’t want is for my money to lose money because I really, really don’t like that at all.
So where then should I put my money?”

From this desire to achieve money growth, the investors of the world look long and hard at the different things they can buy which they have seen historically (any observation of behaviour is defacto historic) increase in value and which they therefore believe they can reasonably expect to continue to do so into the future.

They then (if logical) try to handicap the likelihood of gains against losses for the multitude of different investment alternatives to work out what they think will do best given their time frame and tolerance for volatility and allocate their capital accordingly.

It’s all about the values

This is where a seemingly fairly straightforward goal; to buy shares that after purchase get a lot more expensive, is actually far more difficult, especially over shorter time periods, than most intuitively assume.

But rather than me waffling on about esoteric investment theory stuff, it’s possibly more interesting in illustrating this observation to look at and evaluate investment options currently and their various complexities.

  1. Shares
  2. Bonds
  3. Property
  4. Technology
  5. Cash and equivalents
  6. Commodities

Quickly before that however, there is one observation that will inform the backdrop to everything that follows so is worth spending a few lines on.

People are hardwired to equate risk to and be more fearful of something bad that they have observed happen and therefore be overly concerned that it will repeat.

Conversely if something hasn’t happened for a protracted period, people can cease to be fearful of a negative occurrence and become desensitised to the risks.

This is the essence of why asset bubbles form and crashes happen, but at a less dramatic level it’s why it’s difficult to invest successfully in general.

Investors will be emotionally drawn to those assets that they have observed as having increased in value consistently and impressively and they will be emotionally repulsed by those which have fallen; the biggest and longest decliners will be generally the most reviled.

Shares

This is where we get into the ‘value’ part of this piece. This is the usable practical stuff!

The first thing to say is that by and large the return on a single company’s share price (this is generalised) over time will on average be the amalgam of the inflation rate, the dividend it pays and its growth rate of its profits net of inflation and the dividend.

As a market (say the S&P 500) the growth rate of the index as a whole will be the inflation rate plus the average market dividend plus the average profit growth less the average dividend.

To put this into figures the average increase in the FTSE should be currently around 7-8% pa.

Inflation is around 2.5%, dividend average 2.5% and a net profit average of 2.5% then that gives you the 7-8% total return.

Over the last 30 years market returns averaged about 10% but there was for a large part higher inflation rates so adjusted down for those, the current figure is in line.

This sounds all lovely and easy, an investor gets 7-8% pa from investing in shares, excellent.

“Make mine a double Dave and have one yourself on the slate” (Mr A Daley)

BUT NOT SO FAST (as the saying goes “Drive slow and enjoy the scenery, drive fast and join it”)

The above calculations are predicated on a series of averages.

One of those averages is the price paid for a share or the index level when bought.

The assumption is that they are at their medium point or in market speak, ‘at fair value’.

This is the Goldilocks price of not too hot or too cold but just right.

Now the key to the valuation as above is the excess profit element.

If a company is growing profits strongly then the share price will grow theoretically by the same percentage, all other things being equal.

This is measured in the markets by the price to earnings ratio which illustrates the multiple of profits a company or market is selling at.

The multiple for a company will vary depending on a number of factors but the primary driver is growth of the company and expected profit increases in the future.

So, if we remind ourselves of the observation that from a behavioural investment bias investors tend to buy the assets that have increased profits and therefore share prices, this then suggests that they are prone increasingly over time (and as long as the trend stays intact) to pay a rising premium or a price ‘above fair value’.

Now there have been hundreds of books written about valuing shares and all of them will be better than I could produce, but I hope the interesting core and serviceable observations from the above are simply that:

  1. The return on shares is highly satisfactory on average.
  2. The destroyer of returns is overpaying for the asset at outset. It is therefore not so necessary to pick winners but to avoid mistakes. That this asset class should not be chased above a fair value price. That the key to that is the profit outlook for a company or economy medium term.
  3. Currently most stock markets trade at average profit multiples, so around ‘fair value’.
  4. The US is a tad high but equally its growth is higher, which mitigates this if these current levels are maintained.
  5. No market is cheap, but none look frothy by the above metrics.

The next part of this series will look at valuing Bonds and Property.

Note: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.

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