Advanced Valuation Concepts: The Art of Valuing Stocks

Stock valuation is both an art and a science. In November, we looked at some basic valuation concepts. In this article, we’ll look at some advanced valuation concepts. Basically, we’ll drill down into the “art” part of valuing stocks.

Knowing stock valuation methods is important for equity investors. Now, there are several approaches to valuing stocks, including absolute and relative valuation. However, investors and sell-side analysts generally use ratio analysis to value stocks.

Now, valuing stocks is both an art and a science. As for the science part, we need to use the correct ratio for the industry and the stock that we’re exploring. You can read PE Ratio and the Basic Science of Stock Valuation to explore more about basic valuation concepts. In this article, we’ll look at some of the more advanced valuation concepts and analyze some real-life examples.

Generally, the convention is to value stocks based on the forward or next-12-month (or NTM) numbers. For example, U.S. Steel (X) is valued at an NTM EV-to-EBITDA of 5.9x. On the face of it, the valuation multiple looks in line with historical averages considering its five-year and 10-year averages of 5.8x and 5.6x, respectively.

However, it’s worth noting that forward earnings estimates are based on analysts’ earnings estimates. They are far from perfect, like our valuation numbers! US steel prices have been on an uptrend over the last month, driving U.S. Steel and other steel stocks higher.

Earnings estimates a month ago didn’t seem to factor into any rise in steel prices. In Why US Steel Short Sellers Might Lose on Their Bets, we noted why the stock looked ripe for a rally.

Furthermore, let’s consider that U.S. Steel stock was valued at an EV-to-EBITDA of 2.5x in December 2018. Now, that’s a way too low for a steel company. However, the low valuation multiple was due to high forward earnings estimates.

Generally, analysts’ earnings estimate generally lag the movement in underlying commodity prices. However, equity markets are more efficient than analyst estimates, and stock prices move much before analysts change their earnings estimates.

In this case, the low valuation multiples reflected the markets’ pessimism toward US steel prices and U.S. Steel’s earnings outlook. Incidentally, while analysts had elevated earnings estimates for steel companies, that didn’t turn out to be the case.

US steel prices fell sharply in the first half of 2019. After US steel prices plunged, analysts downwardly revised their estimates, and the valuation multiples started to look reasonable. Simply put, low valuation multiples in December 2018 didn’t really justify a “buy” signal.

Another aspect that we need to consider is that for metal and mining companies, valuation multiples tend to peak near the bottom of the cycle while they hit their bottom at the top of the cycle. Continuing with U.S. Steel’s example, it was valued at an EV-to-EBITDA of 18x in February 2016. That was a cyclical bottom for steel prices as metals plunged in 2015 amid concerns over China’s slowdown.

US steel prices and other metal prices rose sharply after Q1 2016. Plus, analysts raised their earnings estimates after the stock prices had already run up.

In this case, markets priced in higher steel prices well before analysts could revise their earnings estimates higher. In other words, the sky-high valuation multiple in February 2016 was not a signal to sell U.S. Steel. So, a low or high valuation multiple doesn’t always reflect an undervaluation or overvaluation, respectively.

Generally, it is the convention to look at the NTM numbers. However, at times it’s prudent to look beyond one-year earnings estimates. While U.S. Steel’s earnings are expected to be subdued next year amid weak steel prices, they’re expected to rise in 2021. Beginning in 2021, it expects to realize significant financial benefits from its ongoing asset revitalization plan. Freeport-McMoRan (FCX) could be another example. The company looks quite overvalued, looking at its NTM EV-to-EBITDA of 8.6x.

However, its 2021 EV-to-EBITDA looks much more reasonable at 5.3x. In 2019 and 2020, Freeport’s earnings are expected to be low due to the transition at its Grasberg mine. The mine, which is a key driver of Freeport’s earnings due to its low-cost operations, is shifting operations from overground to underground, which is hurting production and earnings in the short term. Read Freeport-McMoRan: Should You Think Like Warren Buffett for more analysis.

So far, we’ve only looked at examples from the metals and mining industry. Meanwhile, Tesla (TSLA) could be another example where we need to look beyond one-year multiples. Valuing Tesla stock is a conundrum in itself, and the stock could be an example of behavioral bias in investing. However, that would be a separate article in the future.

It’s not prudent to comment on Tesla’s valuation based on one-year forward multiples. For valuing Tesla we need to look at possibly its 2025 multiples. Here again, I wouldn’t place my two cents on analysts’ estimates. There is a lot of divergence between what analysts have predicted for Tesla’s earnings and its actual earnings. In Q3 2019, Tesla crushed earnings estimates, triggering a short squeeze. However, in Q1 2019 and Q2 2019, it missed estimates by a wide margin.

While doing cross-sectional analysis in stock valuation, we need to be watchful of why a particular stock has a low or high valuation multiple. All things being equal, companies with a strong balance sheet and high profit margins command a higher valuation multiple.

Taking another example from the steel industry, Nucor (NUE) has historically had higher valuation multiples compared to its peers. The company’s financial leverage ratios are lower than its peers, and markets give it a premium valuation for that. Its profit margins are also stable compared to U.S. Steel. While U.S. Steel might appear undervalued at times, there is a reason that markets give a lower valuation multiple to the stock.

Also, investors can give a valuation premium for patents or other such intangible assets that might drive value in the long term, although they might not reflect in near-term earnings. In Tesla’s case, its Autopilot can drive value in the future. Also, it might license its software to other automotive companies in the future. These growth drivers don’t reflect in its current earnings.

At times, companies command a higher valuation multiple, as markets expect value unlocking in the future. At times, companies have some assets like real estate on their books that don’t contribute much to earnings. However, through spin-offs, such assets can realize their value. Such aspects would not reflect in valuation multiples that are based on earnings estimates.

Markets also give a premium to companies due to their management. Although many might not agree, Tesla’s high valuation multiples might be due to the fact that Elon Musk is at the company’s helm.

While many see Musk as a visionary, short-sellers don’t have a positive view of the Tesla CEO. Ashwath Damodaran, who is popularly known as the “dean of valuation,” also assigned a much lower valuation to Tesla. In June, he valued the company at $190 per share. The stock is now approaching $400 levels. Read Tesla Stock: Is the ‘Dean of Valuation’ Wrong on TSLA? for more analysis

To sum it up, stock valuation is both an art and a science. It takes months, if not years, to be in a position to call a stock undervalued or overvalued. One needs to understand the business and the competitive landscape before commenting on the valuation.

Prominent investor Warren Buffett drills deeper into annual reports to understand the business. In our view, if you arrive at a simplistic assumption that a particular stock is undervalued because its PE ratio is low, in most probabilities, you aren’t making an informed decision.