Stock Valuation Methods: Avoid The CAPE Ratio And Discounted Cash Flows

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by: Jeremy Blum

Summary

There are numerous methods used to value stocks including the PE ratio, CAPE ratio, EV/EBITDA, dividend discount model, discounted cash flow and price to book.

The CAPE ratio and the discount models should be avoided in most cases.

The PE ratio and enterprise multiple (EV/EBITDA) are generally useful but have drawbacks, and price to book can be useful in many cases.

Investors use many different models and ratios to value stocks. There is no right method for all occasions. However, there are some that should not be used in most occasions. These include the CAPE ratio, the discounted cash flow method and the dividend discount method. The PE ratio is still the most widely used, though the enterprise multiple is gaining followers. A discussion of each of these, plus price to book follows. Methodologies discussed are for individual stocks, industry groups and the market as a whole.

CAPE Ratio

The CAPE ratio was developed by Nobel Prize winning economist Robert Schiller. It is a PE ratio that attempts to smooth out the ups and downs of a business cycle. It is determined by dividing the stock price by the average earnings of a company over the past ten years adjusted for inflation. The CAPE ratio has numerous problems as discussed below.

1. Most businesses are very different today than they were ten years ago or even five years ago. If you look at the largest cap companies (Apple, Google, Exxon, GE, Amazon, Microsoft and Berkshire Hathaway) most are very different today than ten years ago. They also operate in different markets with different market conditions, different regulatory situations and in different countries. Retail is entirely different than even five years ago. Most publicly traded companies except for utilities, have changed significantly in ten years.

2. Accounting today is different than ten years ago.

3. PE ratios are higher today in part because interest rates are on a 35 year secular downtrend. The reason for the downtrend in rates is more cash looking for a return than in the past (see #4 for reasons for this). Also, Central Banks have taken away a lot of the supply of fixed rate investments driving down interest rates. The CAPE ratio does not account for this.

4. The first rule of economics is price is a function of supply and demand. Demand for stocks has increased dramatically. There is much more cash looking for an investment. Over the past ten years the amount of money in mutual funds, hedge funds, ETFs, insurance companies, 401Ks and sovereign funds have skyrocketed. Meanwhile, supply has decreased. There are significantly less listed stocks in the U.S. than there were ten years ago.

5. The CAPE ratio does not adjust for changes in dividend yield.

6. The CAPE ratio is used in part to determine when to position for reversion to the mean. However, as I showed above, the mean is changing. Also, if you waited for reversion to the mean, you would have entirely missed the 2002-2007 expansion.

7. Like the enterprise multiple it is time consuming to calculate and not published for individual stocks. It may have more relevance to the market as a whole but even there I recommend against it for the reasons listed above.

Discounted Cash Flow

In a discounted cash flow, future cash flow is estimated out usually five to ten years and then discounted back to account for the time value of money. The discount rate is often the company's weighted average cost of capital (WACC). A terminal value is also usually determined and discounted back. The terminal value assumes the company is sold at the end of the time period. The discounted cash flows and terminal value are then added up to determine market value. Discounted cash flow is often used for private equity, for business plans, in certain shareholder lawsuits and by loan underwriters. I see it used here on SA for publicly traded companies a lot. It has several serious flaws that are discussed below.

1. What discount rate you use can have a huge impact on the market value determined. There is no consensus on what discount rate to use though the WACC is often used. The WACC has a large arbitrary component in it. Most discount rates I see are unsupported or poorly supported.

2. I criticized the CAPE ratio for using cash flows from five to ten years ago when the companies were different. The same is true going into the future. The company being valued is likely to be very different five years from now. Estimating earnings in the future gets difficult after going forward one to two years. That is why stock analysts usually don't go farther out than two years.

3. The discounted cash flow model does not account for industry or other macro factors. It generally assumes they stay the same.

4. You can essentially reach whatever value you want by tweaking the discount rate and cash flow growth assumptions. I call it a wish calculation.

Dividend Discount Model

The dividend discount model determines a value by dividing a discount rate minus a dividend growth rate into annual dividends per share. It is more predictable than the discounted cash flow model. However, it worse than the discounted cash flow model as it has the same issues the discounted cash flow model does plus the following.

1. It uses management's discretionary cash flows to shareholders. It in fact only captures one aspect of management's discretionary cash flow decisions, dividends. It ignores other discretionary cash flows such as share repurchases, mergers, and capex used for growth.

2. It ignores total cash flow.

PE Ratio

The price to earnings ratio remains the most common stock valuation method. Earnings are annual earnings per share (EPS). The PE ratio is easy to find online or in print and easy to calculate. The problem is it doesn't always give a good indication of the cash flow of the company. That could be due to high depreciation, amortization, unusually high or low capital expenses, and changes in various current assets and liabilities due to new management policies or industry situations. It also doesn't factor in leverage like the enterprise multiple. Like the enterprise multiple, the higher the ratio the more expensive the stock. Most sophisticated investors use a proforma EPS which excludes non-recurring income and expenses and amortization. It has become common in recent years to exclude stock compensation expense. This should not be done as stock compensation, while non-cash, does affect EPS. The PE ratio, like enterprise multiple and discounted cash flows, is heavily influenced by the expected growth rate.

Enterprise Multiple (EV/EBITDA)

This has become an increasingly used method and is starting to replace the PE ratio. EV/EBITDA is enterprise value divided by earnings before interest, income taxes, depreciation and amortization. Enterprise value is stock market cap plus all debt minus cash and cash equivalents. Also, usually included in enterprise value is minority interests and preferred stock. It generally gives a better depiction of cash flow than the earnings used in the PE ratio. It also takes into account leverage, which the PE ratio doesn't. It can give a better valuation of low profitability or no profitability companies than the PE ratio. However, it has the following challenges.

1. PE ratio is easier to use at is it published everywhere while the enterprise multiple is generally not published. You usually have to determine it yourself. That is a bigger problem for individual investors who don't have the time or perhaps even the skills.

2. It does not factor in maintenance capex requirements. It is in fact not usable for industries where depreciation is similar to maintenance capex like truckers or vehicle or equipment rental companies. Professionals may factor in capex requirements but it's a difficult calculation that often requires a call to management.

3. It is not useful for banks and other finance companies which have little depreciation and amortization and where most interest is an operating expense, not a financial expense.

4. There is no frame of reference. Little is published as to what an average enterprise multiple is. There is little history of what enterprise multiples were in the past. Overall market average PE ratios are very available while overall market enterprise multiple averages are not.

Price to Book Value Ratio

Price to book value is market cap divided by the book value of net worth. This measurement is often used by value investors as a screen for undervalued stocks. To be truly effective, tangible book value should be used. Tangible book value subtracts all intangible assets such as goodwill that cannot be sold on their own. I usually subtract deferred income taxes though a case can be made not to. This measurement is important in certain financial industries such as banks and insurance companies. Value investors like to buy stocks trading below tangible book value. However, if that is your primary criteria, calculate the estimated market value of the assets. Many assets such as furniture, fixtures and leasehold improvements may have a liquidation value of pennies on the dollar if sold. Others such as real estate may be worth a lot more than the depreciated book value shown. For many industries, such as tech and consumer products, this ratio has little value. Those industries often have significant intangible assets not on the balance sheet that do have value.

Conclusion

The CAPE ratio and discounted cash flows have little value in most cases for publicly traded stocks. Price to book is of value for financial companies and non-financials trading near or below book value. Many professionals have moved to the enterprise multiple. This ratio has advantages over the PE ratio but has numerous drawbacks. For me the biggest one is the fourth reason I gave. There is little frame of reference for what an average enterprise ratio is or has been in the past. It is very useful in comparing companies to their peers, but less useful in comparing them to the market.

I still prefer to use the old-fashioned PE ratio. I like that there is a long history to look at and compare to for individual companies and the market as a whole. I make adjustments for leverage, liquidity, red flags, amortization and depreciation that exceed maintenance capex. Once the enterprise multiple starts getting published for all companies, and averages disclosed over time, I may change my mind.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.