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7 Ways To Gauge Growth And Evaluate Value

Growth and value are cornerstones of fundamental analysis. Here we explore some of the most popular methods of gauging a company’s growth and a stock’s value. “Growth” and “value” are thought of as two very significant metrics in the world of fundamental analysis , two things that can cause a trader to buy, sell, or ignore. But what is growth? And what is value? These are words we hear and read every day, and that most people think they can easily define. You might think that a musician’s songwriting has grown, or you might give (or get) what you believe to be valuable advice. But in both of these instances, growth and value are subjective-matters of perception. But when it comes to the markets, growth and value are not so subjective. Rather, they are things that, for the most part, can be measured or weighed. Growth refers to a company’s performance, whereas value applies to its stock price. Moreover, there are very specific ways of gauging growth and value. Here we’ll discuss seven popular ways of doing just that. GROWTH: Past, Present, and Future. In simple terms, growth describes earnings. There are three different ways of looking at those earnings: past, present, and future. 1. The Past: Historical Growth As the common disclaimer goes, “past performance is not indicative of future results.” And as true as that may be, it doesn’t mean that it’s not good to know a company’s past. With that in mind, many traders and investors look at a company’s historical growth, which is really just a catchy way of describing the company’s annualized earnings in the past. When there exists a consistent increase in annualized earnings, there exists historical growth. 2. The Present: Free Cash Flow When it comes to measuring growth (or growth potential), some traders and investors like to follow the cash or, more specifically, the free cash flow. Free cash flow is, put simply, the difference between cash in and cash out. When there’s significantly more cash coming in, the free cash flow is strong. When the cash coming in is close to (or less than) the cash going out, the free cash flow is weak. Companies with strong free cash flow may have capital for R&D, acquisitions, etc. In other words, things that may very well help it grow. 3. The Future: Projected Growth If you’re going to look back, you may also want to look ahead. But where a company’s historical growth can be calculated by looking at their past performance data, a company’s projected growth is determined by analysts who look at a variety of information, including a company’s current and recent finances, as well as its stated objectives and outlooks. VALUE: Price Comparisons Growth places a heavy emphasis on, of course, growing. Value, however, does not. (After all, not every company aims to keep expanding, or even growing, its earnings. Some companies, whether they want to or not, just stay relatively consistent.) Value looks at the price of the company’s stock relative to the performance of the company, regardless of whether or not the performance is improving. Here are four popular ways of gauging the value of a stock. 1. Price to Earnings Ratio (P/E) This metric takes the stock’s price and compares it to the company’s earnings. It does that by dividing the stock price by the earnings per share (EPS). A “normal” P/E ratio is typically 20-25 times higher than the EPS. So a stock with a “normal” P/E ratio may be trading at $20/share, and have an EPS of $1/share. In this case, the P/E ratio is 20. Perhaps you can see where this is going: If a company is earning more money per share, but it’s not reflected in the stock price, the P/E ratio can be low (lower than 20), and this can suggest that a stock is undervalued (and thus, may be a good buy). For example, remember the example stock that was trading at $20? Now, let’s say its EPS is $5. The P/E ratio for that stock would be 4, which may suggest the stock price should go up to reach normal range. Or, consider the reverse: the stock is trading at $20, but the company is only earning $0.50/share. Now it has a P/E ratio of 40, which suggests the stock may be overvalued. 2. Price to Book Ratio (P/BV) To arrive at this measurement, you have to consider a hypothetical, which is to say, you have to know its book value. A company’s book value is the theoretical amount that every share would be worth if the company were to be completely liquidated. That number is then compared to the actual share price of the company. The result is the P/BV, or Price to Book Ratio. If the ratio is low (meaning the price is lower than the book value), the stock may be undervalued. 3. Price to Sales Ratio (P/S) How does a company make money? One major way is by selling, some in a traditional retail sense, and others in a more abstract sense (by selling its ideas or services). Regardless, since sales are often a significant source of money for a company, many traders and investors like to compare a company’s sales to its stock price. Here they do this by actually breaking down the sales to a per-share amount. With this figure, they formulate the Price to Sales Ratio. Like the above two ratios, a comparatively low stock price means a low ratio, which may be indicative of an undervalued stock. 4. Dividend Yield and Historical Rate of Dividend Growth Since dividends are cash payouts that companies pay their shareholders, dividends can be an important thing to many traders and investors. For one thing, dividends can allow a shareholder to earn income without actually selling the stock. And for another, the amount of dividends can be a good indicator of the health of the company. To take a deeper look, many users of fundamental analysis will look at a company’s dividend payment history. Consistent and increasing dividends may be a sign of a strong company, and a stock price that has not grown along with those dividends may be a sign of an undervalued stock. So, in the end, when you think about growth and value, think about these seven points. For growth, there’s the past, the present, and the future. And when it comes to value, do price comparisons-against earnings, against book value, against sales, and against dividend yields. Disclosures Schwab does not recommend the use of technical analysis as a sole means of investment research. The information here is for general informational purposes only and should not be considered an individualized recommendation or endorsement of any particular security, chart pattern or investment strategy. Past performance is no guarantee of future results. ©2015 Charles Schwab & Co., Inc. ( Member SIPC ) All rights reserved. (0614-4161)

Why The World Appears More Uncertain

Why the World Appears More Uncertain In Image 1 , you will see the counties in the lowest decile of the kidney cancer distribution. As soon as we see an image like this, our brains immediately set about the task of explaining why it is that the healthy counties appear to be mainly rural. Perhaps it is a result of breathing in unpolluted air, consumption of fresh food delivered straight from the farm to the table, or maybe it’s the availability of clean water delivered by tranquil streams. As it turns out, the explanation has nothing to do with the environment or lifestyle, but I’ll come back to this in a moment. A young auto racing team has had a phenomenal year, finishing in the top five in 12 of the 15 races it completed. Unfortunately, the car failed to finish due to a blown engine in the other 7 outings. A decision needs to be made whether or not to enter the final race of the season on this particularly cold morning. Several major sponsors have taken notice of their performance and the team is on the cusp of moving from struggling upstart to a power player with significant financial resources. If they finish in the top 5 again today, they will certainly hit the tipping point to success. However, another blown engine will likely send them back to square one, or worse. Their engine mechanic, a true “grease monkey” believes the problem has something to do with ambient air temperature, but the chief mechanic, an engineer, disagrees. As proof, he provides the air temperature for each race in which they experienced a blown gasket, highlighting the fact that the problems occurred across a full range of temperatures (see Figure 1 ). More on their decision in a bit. Baseball has just entered the postseason, that moment when the 30 teams that have been competing to win the World Series are reduced to the top 8. It’s also the time when experts begin making predictions. As it is with all sports, the experts place great emphasis on momentum, particularly recent momentum. As an example, here is how one article on SBNation.com begins. “Rule No. 1 of predicting the postseason: Pick a very strong team. The Blue Jays are rolling. They have the best team, clearly.” It isn’t just the “experts” though. We all do it. For instance, if you were attempting to predict the outcome of the very next at-bat for a major league baseball player, which of the following do you believe would offer the most predictive value? His batting average over the last five plate appearances His batting average over the last five games His batting average over the last month His batting average over the season so far His batting average over the previous two seasons If you’re like most people, you would order the predictive power exactly as it is above. However when Moskowitz and Wertheim studied all MLB hitters over an entire decade, it was the batting average of the previous two seasons that offered the most predictive value. In fact, if you wanted to order the list above from most valuable to least in predicting the outcome of a batter’s next time at the plate, you’d need to flip it completely. Interestingly, they found the same results when applied to the NBA, NFL, NHL and European Football. Let’s return back to the question facing the owners of that auto racing team. Unfortunately, because the chief mechanic had framed the data in a narrow way, the key decision makers hadn’t thought to ask the simple, but important follow up question, “What were the temperatures when the engine did not fail?” Had they done so, they would have quickly discovered that temperature was indeed a key factor in the failures. Truth is, the story of the racing team as presented here is a fictitious one, created by Jack Brittain and Sim Sitkin as a case study for decision making. However, the data provided and the decision of “Go” or “No Go” was a very real one faced by the engineers at NASA ahead of the launch of the space shuttle, Challenger. Unfortunately for all involved, because the problem was initially framed very narrowly, some rather informative data, the kind that surely would have resulted in a “No Go” decision on that cold morning (see Figure 2 ), was missed. This is such a powerful story, because it shows that even the smartest among us are vulnerable to poorly framed problems resulting in all the difficulties that come with overvaluing small sample sets. Truth is, the annals of history are littered with similar mistakes by equally intelligent, educated and successful individuals, which is why it shouldn’t be hard to believe that this same mistake is made on a regular basis by professional investors, including the most successful ones. Let’s return to where we started this edition, by contemplating why it is that rural living results in lower incidents of kidney cancer , but first, some additional information before we get too deep in the creation of an intelligent sounding narrative. Image 2 shows the counties in the top decile of the kidney cancer distribution. Once again, rural areas dominate. If you had been presented with this image first, you would likely have jumped to the conclusion that the high rates might be due to higher poverty rates, limited access to proper medical care, greater propensity for smoking and drinking alcohol, or perhaps diets that tend to be higher in fats. The truth is, there is no valid narrative that can accurately explain the phenomenon. It is merely a function of studying a small sample set, but rather than chalk it up to the random, highly variable nature of small sample sets, we intuitively set about the task of generating a story that can explain it. Unfortunately for us, regardless of what we desire, small towns represent small sample sets and small sample sets typically exhibit greater variability and so tend to be overrepresented in the tails, both of them. It really is that simple. Back in 1984, a little known paper was written by Robert Abelson of Yale University where he proved mathematically that the percentage of variance in any single batting performance for major league baseball players explained by skill is less than one third of 1%. The author’s hypothesis, which led to the proof was that “many games are decided by freaky and unpredictable events such as windblown fly balls, runners slipping in patches of mud, baseballs bouncing oddly off outfield walls, field goal attempts hitting the goalpost, and so on… The ordinary mechanics of skilled actions such as hitting a baseball are so sensitive that the difference between a home run swing and a swing producing a pop up is so tiny as to be unpredictable, thus requiring it to be considered in largely chance terms.” While proving that skill played a minuscule role in an individual swing and at-bat, he did acknowledge that over sufficiently lengthy periods, skill was indeed a significant factor. Considering the high degree of variability and uncertainty inherent in very short term results, not to mention the volumes of research proving that small sample sets are more volatile, less predictable and less informative, it should make you question the decision making ability of portfolio managers, CIO’s and asset allocators who, in the face of turmoil and uncertainty, actually shorten their investment horizon. Although it appeals to our intuition and therefore feels right, focusing on progressively shorter term price action in order to gain greater control of your p&l volatility is quite simply, irrational. By shortening your time horizon, allowing both short-term price action and every individual data point, including non-farm payrolls, to drive your investment decisions, you are in fact increasing the influence of noise over signal, randomness over predictability, and injecting volatility into both your thought process, and results. Ironically, as more and more investors and their money managers attempt to reduce volatility and increase their sense of control by becoming hyper focused on what has just happened, their decisions become more sensitive to noise and their results more volatile. With this behavior having become so pervasive, it’s no wonder markets appear more volatile and less predictable these days. When you shift your focus away from the big picture, where trends are far more apparent and explicable, it’s only natural that the world would appear to be less certain, more volatile. The truth is, we can’t actually explain every tick in the S&P 500 or weekly move in wheat. In the scheme of things, these are little more than random events. When we continuously attempt to create seemingly coherent narratives to explain what are essentially random events, we will naturally experience more moments when our expectations are proven wrong than when we weren’t so myopic. Rather than accept responsibility for the mistake, we tend to place blame externally, which in this case leads to the explanation that the world no longer makes sense, that it is more volatile and uncertain. But, if we step back a bit, pull those charts back, consider what the really big forces are that are truly driving global economics and financial markets, we can see that the world hasn’t actually become more uncertain. The uncertainty is merely a function of how the problem is being framed, which is leading to poor decisions, lower returns and greater volatility, en masse. When that occurs, risk parameters tend to be tightened up even more, thereby exacerbating the problem, which is where we find ourselves today.

It’s Not Possible For A New Understanding Of How Stock Investing Works To Become Popular Without People Losing Confidence In The Old Understanding

By Rob Bennett Valuation-Informed Indexing is the future. Buy-and-Hold is the past. Or at least so I believe. But as of today, Buy-and-Hold is far more popular. About 80 percent of stock investors do not believe it is necessary for them to change their stock allocations in response to big valuation shifts. Another 10 percent see the merit of the idea, but are reluctant to adjust their allocations too much, because few investors do this, and they see risk in going against conventional opinion. About 10 percent follow a Valuation-Informed Indexing strategy. I want to spread the word about the new model, which I view as the first true research-based strategy (because Shiller’s 1981 finding that valuations affect long-term returns discredited the belief rooted in Fama’s research that the market is efficient). So I need to point out the dangers of Buy-and-Hold. I wish it weren’t so. I greatly admire the Buy-and-Hold pioneers. I buy into all of their beliefs except for the one about there being no need for investors to take price into consideration when buying stocks. Moreover, the 80 percent who believe in Buy-and-Hold are offended when I find fault with the strategy. If there were some way to make the case for Valuation-Informed Indexing without criticizing Buy-and-Hold, I would win over a lot more people and encounter a lot less friction as a result of my efforts to do so. It can’t be done. Fama said the market is efficient. That means stocks are always priced properly. Buy-and-Holders often object to that statement. They say an efficient market is just one in which all available information is incorporated into the price, but the price that results is not necessarily the right one. That’s a hyper-technical distinction. If the market price incorporates all known information, the market price is as close to perfect as it could possibly get. Buy-and-Holders are essentially saying the market price is always right. If the market price is always right, indicators of overvaluation and undervaluation are meaningless. Buy-and-Holders don’t consider valuations when buying stocks for a logically sound reason. They don’t believe valuation metrics tell us anything. According to the Buy-and-Hold model, the P/E10 value is noise. Shiller showed the P/E10 value is not noise. It effectively predicts long-term returns. By undermining the foundational belief of the Buy-and-Holders, Shiller turned our understanding of how stock investing works on its head. It’s not true that stocks are risky; the risk largely goes away for investors who take valuations into consideration when buying stocks. It’s not true that the safe withdrawal rate is the same number for all retirees; the safe withdrawal rate is a number that ranges from 1.6 percent when stocks are priced as they were in 2000 to 9 percent when stocks are priced as they were in 1982. It’s not true that bad economic times cause stock crashes; stock crashes become inevitable once overvaluation gets too out of control and the losses experienced in the crashes cause consumer spending power to dry up and the economy to falter. Shiller’s finding is all positive. It’s like the discovery of electricity; it leaves us all big winners. But it represents a big change. Shiller’s finding will eventually take us to a very good place, but starting a national debate regarding the implications of his finding has been a disruptive experience. How people invest to finance their retirements is an important and sensitive matter. Telling people they got it all wrong upsets them. People want to move forward in their understanding. But it hurts them to let in the knowledge that they could have earned higher lifetime returns at less risk had they caught on to the significance of the Shiller revolution earlier in life. The normal way for a new idea to catch on is through exposure in the marketplace of ideas. When the Beatles showed up on the Ed Sullivan show with their long hair, a debate was launched as to whether it was okay for men to wear their hair at that length. Arguments were advanced from both sides of the divide in opinion. Eventually, a resolution was reached in the minds of most people. The Beatles won that one (for the most part, but not entirely). Most people of today find long hair acceptable on men. The big problem in the investing realm is that the debate has not yet been successfully launched. People who believe valuations matter keep quiet about it when they are speaking in the presence of Buy-and-Holders. It is viewed as rude to mention how dangerous Buy-and-Hold will prove to be if it turns out Shiller really is on to something. There’s no way to know for certain that Shiller is right. The historical data supports him. But data from earlier times can be dismissed on the grounds that the economic conditions under which that data was produced no longer apply. And the data from the time of Shiller’s finding until today is inconclusive. From 1981 forward, Buy-and-Hold has performed slightly better than Valuation-Informed Indexing. Valuation-Informed Indexers say that’s because stock prices are high today; Valuation-Informed Indexing will be revealed as the superior strategy with the next price crash, which is inevitable, according to the Shiller model. But that way of thinking about things begs the question: to say Valuation-Informed Indexing will prove superior because today’s valuations will produce another crash is to say Valuation-Informed Indexing will prove superior once again because Valuation-Informed Indexing has always been superior. The crash hasn’t come yet. So we don’t know for certain. To be fair, the Buy-and-Holders are begging the question too. They say we cannot know that another crash is coming soon, because the market is efficient and returns are thus not predictable. All of the beliefs of those following both strategies follow from their core premises. If the market is efficient, Buy-and-Hold is the ideal strategy. If valuations affect long-term returns, Buy-and-Hold is dangerous. I believe I need to point that out to my Buy-and-Hold friends. I don’t want to hurt their feelings. I want them to consider what might happen to their retirement portfolios if it turns out Shiller is right. I criticize their strategy not to upset them, but to alert them to a new way of thinking about how stock investing works that I strongly believe we all need to know about. Disclosure: None.