This year, the idea of valuing investments based on true valuation metrics has basically flown out the window. We have no idea what a company is worth until earnings can stabilize, and the only way that will happen is when COVID-19 is fully under control. For now, we have momentum investing as the primary catalyst for the market upside. Earnings for many tech and communication services companies are also strong and that should continue in my opinion. However, since 95 percent of the stocks in the market are down or flat year-to-date, is now the time that valuing stocks correctly is more important than ever? Most articles published today are normally opinion pieces on why you should buy something or sell something. This article specifically tells you how you can value a stock and why a company might be valued where it is.
The Market Capitalization of a Company
This is what the general stock market thinks this company is worth. Let’s use Zoom as an example, as this is a company that has “zoomed” up (stock symbol: ZM). Zoom has roughly 284 million shares outstanding. As of October 1, the stock was trading for around $470 a share. If you take the number of shares outstanding times the price of the stock, you get the market capitalization or value of a company. This means the market values Zoom at $133 billion. Is Zoom worth $133 billion? As they say, “A company is worth what someone is willing to pay for it.” However, in the stock market, things can change very quickly.
To start the year, Zoom opened at $69 a share. It was worth about $16 billion. So, Zoom has increased its value by eight times in just 10 months. Normally, this would tell us that the earnings of the company are strong, it is expected to be strong in the future, or maybe they are poised for a merger or acquisition. Stocks are broken down into three main capitalization ranges: small cap, mid cap and large cap. Small cap companies have $2 billion or less in market capitalization. Mid cap companies are between $2 to $10 billion. Lastly, large cap companies go from $10 billion and up.
Smaller companies tend to be smaller, nimbler and can grow faster. There’s also more risk as the company doesn’t have the same resources that a large cap company would have. Conversely, large cap companies tend to have less risk, which in turn can have less return than small cap companies. However, as in almost everything this year, there are exceptions to the norm. Large cap companies have outperformed small cap companies year-to-date.
Earnings and Price to Earnings
The earnings of a company are what the company makes net of expenses. Obviously, the more profitable a company is, the more the company should be worth. The most important thing to determine is if a company is a growth or value company. If the company takes all of its profits and uses that for new workers, equipment and acquisitions, it tends to be labeled as a growth stock. If a company uses a sizable portion of its earnings to pay dividends, it tends to be labeled a value stock. Value stocks are a lot easier to try to put a value on as they tend not to grow as fast, and they are using some of their cash flow on shareholders rather than strictly on growing the company’s bottom line. This also makes their future earnings expectations not as robust. So, value stocks tend not to be as thrilling and are normally not the companies that are up 200 percent for the year. A low price to the earnings of a company, long term, tends to be a good investment, as long as the future of the company is strong. So, for value stocks, the price to earnings ratio tends to be used along with other metrics.
Since many growth companies operate at a loss for a while, as they are putting all of their resources into growing, looking at traditional price to earnings doesn’t help since a company looks like it is losing or barely making money. So, earnings growth, projected growth, future earnings expectations and free cash flow are more important for growth companies. Zoom is an example, as it is trading at 1,000 times its earnings for the year. Valuation of these up-and-coming growth stocks currently is almost nonexistent using traditional price to earnings metrics, whereas a Coca-Cola tends not to be as robust and can be valued easier as its numbers are more stable.
Valuing a stock based on specific metrics is not hard to do as you can find these metrics on most financial websites. An important thing you need to determine is what sector the stock is in. Many companies or analysts might label a stock in a sector that maybe doesn’t fit. We know Verizon fits into the communication services sector. However, some analysts look at Tesla as a car company putting it in the consumer discretionary sector. In my opinion, Tesla is a technology company due to their innovations in battery creation. One of the main reasons this stock has flown up is the future innovations of the company.
Why is this important you may ask? Well, each sector and the stocks in that sector tend to trade in a historical range. As an example, the historical price to earnings ratio average for large cap health care stocks in the last five years is around 31. However, you should also look at each stock individually and their historical P/E ratio as well. How well do they match up to their peers? That is why knowing what sector the company is in is an important step in the valuation process. All the other valuation metrics, such as free cash flow, price to sales, price to book, and some other fundamental metrics, rely on knowing how the other stocks in the sector are valued.
The News of the Day
The news of the day also plays a key factor to the stock price. There are tons of media outlets that report news about these publicly traded companies on a minute-by-minute basis. For example, Johnson & Johnson (stock symbol: JNJ) is in the running for the vaccine of COVID-19, which could possibly increase the price of that stock dramatically the minute it is reported. Maybe a report comes out tomorrow that JNJ is the lagger compared to its peers in a timeline for a vaccine shooting the price of the stock way down. Remember when JNJ was going through a lawsuit for its talcum baby powder last year? Well, that would undoubtedly cause volatility in the stock depending on the outcome of that lawsuit.
It seems like every day you hear a news report from an analyst changing their rating of a stock to a buy from a sell and vice versa. While this might be short-term news, it does provide a reason to possibly value the company higher or lower.
Putting It Together
Let’s put all of this together. We just went over a few ways to look at a company’s or stock’s value. However, there are many different metrics used that we didn’t even discuss, such as price to sales ratio or technical chart analysis.
Let’s use a stock that has been around a while and that might be easier to value correctly, Johnson & Johnson. The company has a market cap of $380 billion. Making it a large cap or even more direct, a mega cap ($100 billion and up cap). It is listed in the health care sector, which I feel is the most appropriate placement. This will allow us to look at this stock against its peers. As stated above, the historical five-year P/E ratio average is 31 for the sector. JNJ’s current P/E ratio is close to their five-year average around 18. So, if we just looked at P/E ratio, the stock looks fairly valued against its personal history or undervalued to the sector. But this is just looking at current and historical numbers. The forward P/E ratio takes into account the estimated earnings, which is currently close to 16, making this company look more attractive. JNJ pays a current dividend yield of close to three percent, about 50 percent more than the S&P 500. They increased their dividend in May, even during the pandemic when some companies cut their dividends. They have also increased their dividend each year for 57 years straight!
So, this stock would very much be considered a value stock. If a buyer had bought and held this stock, the shareholder has been getting paid while they stay invested. It also shows management is committed to the dividend. The news is also very positive on JNJ as its vaccine trials are going well. Two of the companies that have an analyst assigned to this company have an outperform rating and an estimated price target of $160. There are 18 analysts who cover this stock, and none have a sell recommendation. So based on history, data, dividends, news and recommendations, all signs point to a buy or at worst, a hold. However, in my 18-year career, I have seen many companies valued at a great price, and then I look back a year or two later and the stock is down by 20 percent. So, diversification and owning multiple names is always a good long-term risk mitigation technique.
I don’t want to make this seem easy. A lot of data is not easily attainable. There is high-cost software that you can use to help you get the most accurate data. However, you really should have a professional or team for this type of research and portfolio construction as this takes a great bit of time. You never want to have all your money heavily allocated to one position. Owning a few companies in each sector is not a bad approach and will help you diversify your risk.
If you have been looking at the stock market as some gambling mechanism, you will eventually get hurt or end up losing your assets. If you value properly, don’t overact, diversify and understand what you own and why you own it, you will be just fine historically. Keep it simple. Stay prudent. Happy investing, my friends!