How to Evaluate Stocks; For Financial Advisors

As advisors, we sometimes forget the basics: a stock represents a fractional ownership interest in a publicly traded corporation. Historically, returns have been higher for owners and partial owners (stocks) than someone who lent money (notes and bonds). Stocks can be characterized by size (capitalization): small cap, medium cap, and large cap. A publicly traded company’s capitalization is calculated by multiplying the price per share by the number of outstanding shares of stock.

There is no universal definition or agreement as to what dollar figure constitutes what level of capitalization. As a generality, a small stock represents a corporation whose capitalization is roughly $1.4 billion or less; $4 billion for mid caps and $10 billion for large cap companies. In the case of mutual funds, the typical small company stock fund holds stocks whose average market capitalization is $2.6 billion. Mid cap stock funds have an average capitalization of $7.2 billion; large cap funds hold stocks whose average size is $100 billion.

These three classifications can be further broken down into growth or value stocks. In general, growth stocks enjoy higher-than-average growth rates of earnings, sales, and/or return on equity. They frequently have high price-to-earnings (P/E) ratios and price-to-book (P/B) ratios. Value stocks typically have low P/E and P/B ratios but comparatively high dividend yields. Value stocks are often turn-around candidates—they have had disappointing news and/or subpar growth.

As an example, as of February 2017, the average large company growth stock fund had a P/E ratio of 23, a P/B ratio of 5.0, and distribution yield of 1.5%. The average large value stock fund had a P/E of 18, a P/B ratio of 2.0, and 2.2% distribution yield.

Stock Valuation

There are three commonly used measurements of stock valuation: price/earnings (P/E ratio), price/book (P/B) ratio, and dividend yield. Ultimately, people buy stocks to own a piece of a corporation’s earnings. If the Widget Company earns $5 a share and its stock sells for $100, it has a P/E ratio of 20; an investor is paying $20 for each $1 of earnings.

As a broad generality, a company in a seasoned industry group selling at a 30 P/E is said to be expensive; one selling at a 10 P/E is said to be cheap. Unfortunately, earnings are not particularly stable. It is possible for corporate accountants to “fiddle” with reported earnings to the point where they are almost meaningless. For these reasons, P/E has only limited value.

Ben Graham, a strong advocate of value investing, pointed out earnings provide useful information only when averaged over several years. Using such logic, one could say mutual fund P/E ratios are quite useful since they are a compilation of dozens and usually well over 100 different companies.

Over the past 80+ years, the stock market’s P/E ratio, as measured by the S&P 500, has ranged from a negative number (during the Great Depression) to over 44 (December 1999). As of early February 2017, the S&P’s trailing P/E ratio was 24 (20 for the Dow), with an estimated current P/E of 18 (17 for the Dow).

A company may not have any earnings, but all companies have a book value. This indicator can be thought of as the net value of a company’s total assets. In the real world, the number is much more complex since there is a fair amount of accounting discretion.

Book value should be considered a “rough” number. Suppose the LMN Car Leasing Company owns assets valued at $5 billion, and its liabilities are $4 billion. Let us further assume the current value of all its outstanding stock is $2 billion. This means LMN has a P/B ratio of 2 because it is selling for twice its book value ($2 billion stock value and $1 billion net value).

Historically, a stock with a P/B ratio of less than 1 is said to be cheap; a P/B ratio of more than 5 is expensive, at least relative to its book value. The book value of a stock is considered to be very stable. Over the past 80 years, the stock market’s P/B ratio has ranged from less than 1 to 8 (both numbers are exceptions); it has averaged about 1.6. During 1999, the P/B ratio for U.S. stocks was 6 (vs. 4 for European stocks). The ratio has declined since then, leveling off to 2.2 beginning in the middle of 2002 through 2009. The S&P 500 had a P/B ratio of 3.0 as of early 2017.

Next, there is dividend yield. This is simply the amount of a company’s annual dividend divided by its current stock price. If LMN sells for $50 a share and pays out $2 a share in common stock dividends over the course of a year, its dividend yield is 4%. Historically, dividend yield for the S&P 500 has varied between 1.3% (expensive) and 7% (cheap); it has averaged ~ 4% over the past 80 years. Because of low dividends the past several years, validity of this ratio in measuring expensiveness may be questionable. The S&P 500 had a dividend yield of 2.1% as of early 2017.

The following table shows average annual compound rates of return for each of the past several decades for the six major domestic stock categories. Also included are foreign stocks, as measured by the Morgan Stanley EAFE index, the most widely used benchmark for developed markets excluding the United States and Canada. The EAFE index consists of 22 developed countries outside North America; the great majority are mature, large cap companies
 

Stock Market Performance by Decade*  [1970–2016]

  * All figures are annualized

Stocks have enjoyed very attractive cumulative returns during most of these 10-year periods. In most instances, value stocks have outperformed their growth counterparts. For 2016, the EAFE returned 1.0% (for 2008, EAFE was down -43% vs. -37% for S&P, -38% for mid cap, and -37% for small stocks). Large cap (used throughout course) refers to S&P 500 (12.0% for 2016, 1.4% for 2015, 13.7% for 2014), which includes growth and value. 

Disturbing  Return  Figures

Mutual Fund Investor Returns [all periods ending 12/31/2013]

Note: Returns are what equity, asset allocation, and fixed income mutual fund investors actually experienced. Returns for these 3 broad fund categories was higher (differences due to investor panic, moving from one fund to another, cash needs, etc.).