Ratios and Returns

“The way to make money in the stock market is to buy a stock. Then, when it goes up, sell it. If it’s not going to go up, don’t buy it!” Will Rogers

Will Rogers lighthearted but clever remark gets at the heart of investing – finding stocks that only go up (Footnote 1). There are a lot of ways of going about that, but much of it comes down to valuation. Is the company being offered at a fair price? Are we overpaying? Is future growth already baked in?

By definition, a company’s value is the present value of all its future cash flows. But forecasting future cash flows is not an exact science, with many pitfalls (Footnote 2). Rather than try to come up with a precise, but potentially wrong, valuation, we prefer to find an imprecise valuation, and then buy when we’re at a discount to that imprecise valuation – giving us a margin of safety.

“If [the value of a company] doesn’t just scream out at you, it’s too close.” Warren Buffett

One way of finding a company’s valuation is by looking at ratios – versus peers, compared to history, or against good old common sense. There are lots of different metrics you can look at:

• Price to Sales (often used on growth companies that may not be making profits)
• Price to Book (used when balance sheet structure is important, like banks or insurers)
• Price to Free Cash Flow (one of my personal favorites as FCF often eliminates some of the accounting games companies play).
• Enterprise Value to Earnings Before Interest, Taxes, Depreciation, & Amortization (EV/EBITDA, a way to normalize valuations between industries and capital structure).

The most often cited ratio, Price to Earnings (P/E), is simple to calculate: it divides the company’s current price by its annual earnings (Footnote 3), resulting in a ratio showing how many years of earnings you are paying for the company. The lower the P/E ratio, the less dependent you are on future growth to justify the price, in theory, lowering risk.

Johnson and Johnson (JNJ) currently trades at $152 per share. JNJ’s management team expects to earn $10.57-$10.72 in earnings per share in 2024. At the midpoint of guidance ($10.64), JNJ is trading at a P/E ratio of 14.3x. This is near the company’s lowest valuation of the last decade and lower than JNJ’s 10 year mean P/E of 16.6x. It’s also well below the overall market’s valuation.

The S&P 500 can be valued using a P/E ratio. The 500 constituents of the index are expected to earn $218.33 per share in 2024. With the index trading at 5,322, the P/E ratio is 24.4x. That is above the (very) long-term average of 16.3x, but only slightly above the modern (1986-2024) average of 23.5x. Based on historical analysis, the S&P 500 screens as slightly overvalued – not excessively expensive, but not cheap either.

As we’ve noted in past articles, we view the current market as separated into two camps: the high-flying and highly valued Tech names (Magnificent 7, AI, etc.) contrasted with some of the more boring (but dependable) names at cheaper valuations. Combined, both groups produce an index valuation of 24.4x, but separated we see signs of excess in the highflyers, while there are value opportunities in other areas. We have our portfolio skewed to what we view as the better valuations.

The historic data backs us up on buying cheaper stocks. We looked at every month back to 1900 (1,475 months) and compared the month end P/E ratio to the market’s return over the following 12 months. When the P/E ratio was between 10-14x, the S&P 500 returned, on average, 14.1% over the next year. The average return falls to just 4.1% when the P/E ratio is between 26 and 30. There is a clear bias toward buying at discounts and higher returns (Footnote 4).

This isn’t to say buying cheap value stocks is the only solution to investing. Even cheap stocks can be bad investments. They’re called “value traps” – they look cheap, but due to an imploding business model, it’s just an illusion. Kodak in the late 90s and early 2000s was the textbook example – a company with a storied history, great (past) financials, trading at ~10x earnings. But you had to step back and recognize that their competitive advantage was slowly eroding due to digital competition.

“If you were to distill the secret of sound investment into three words, we venture the motto, ‘Margin of Safety.’” Benjamin Graham

Margin of safety – having a fallback in case you are wrong (and you will be wrong at times), is the key to investing. One of the best margins of safety is a discounted price – and looking at the company’s ratios is a good starting point.

If you have any questions about your account(s), if there has been a change in your financial situation or investment objectives, or if you’d like to schedule a complimentary consultation to learn more about how our team can help you navigate the market and achieve your long-term financial goals, please feel free to contact us at (406) 839-2037.

1. You won’t find stocks that only go up. This is a game of averages. Even some of the greatest stock pickers in history [Warren Buffett, Peter Lynch, Joel Greenblatt, etc.] outperformed on just 51-60% of their investments. But thanks to compounding, even slight statistical advantages can lead to amazing outperformance.
2. Modeling a company’s financials (revenue, margins, capital expenditures, etc.) 10, 20, or even 50 years into the future is nearly impossible. And even slight changes in your growth assumptions can drastically change the present value. It’s like looking through a telescope. Move the telescope even slightly, and all of the sudden you’re looking at a whole new galaxy.  It’s the same with discounting future cash flows, making them very precise, but often very wrong.
3. Check how earnings are defined, as it can be a number of different methods. It can be the last twelve months’ GAAP (generally accepted accounting principles) earnings. It can be calendar year earnings, or forward earnings expected by analysts, or earnings adjusted for what the company deems “one-time” items like restructuring or litigation expense. Like many things on Wall Street, the devil is in the details.
4. Sometimes, when the P/E ratio of the market goes above 30x, it is due to a deep recession, like early 2009. Earnings were depressed due to financial write-offs, pushing the ratio higher. But that can be a great time to buy stocks, on the cusp of an economic recovery. When the P/E ratio reached 110x in early 2009, the next 12 month return for the market was +56%; things had become so bad they were good.

Data Sources: Koyfin, Shiller Online Data Set, S&P Global, Allied Calculations

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