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How to Select the Optimal Valuation Method to Build Better Price Targets (Part 1 of 3)

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Buy-and-Sell-300x166In a prior post I noted all stock picking best practices (or “tips”) can be put into one of the four elements of our TIER™ framework (see image below).

If you’re asking “why should I care?”, I’d reply that the best stock pickers have a consistent philosophy and methodology for picking stocks. If you already have one, that’s great, but if you’re looking for one, you might want to start here and make modifications to fit your style or investment philosophy. This 3-part series focuses on the “T” of the TIER™ framework shown below.

TIER Framework

At the risk of over-simplifying this discussion, the two basic elements of every price target are the A) financial forecast; and B) valuation multiple (e.g. P/E, PEG, DCF discount rate). Due to space constraints, I’m not going to delve into financial forecasting in this post because it’s such a significant topic, other than to say the best analysts have a financial forecast based on fundamental research and not simply management’s guidance or a “hunch” that differs from consensus.

The optimal valuation method isn’t always the most rigorous…it’s the one that will capture the market’s psychology when your price target is expected to be achieved

Here are some best practices for selecting the optimal valuation method:

  1. Before applying a valuation multiple to a financial forecast, determine the optimal valuation method. Notice I didn’t say the “best” method, because this might cause an analyst to conclude the most rigorous (such as DCF) should always be used. Identify the valuation method(s) currently being used for the stock and sector, as well as any other methods used in the past, by reviewing publicly-available research reports and speaking with market participants who have been involved with the stock over an extended period of time (e.g. buy-side analyst, portfolio manager, sell-side analyst, sell-side salesperson, investor relations contact of target stock, investor relations contact of competitor of target stock, etc.)

    When I arrived at my first job as an equity research analyst, I thought I’d use my newly-minted masters degree to show the world how they should be looking at my sector “correctly”, specifically on a DCF basis, even though the stocks had been valued by most on a P/E basis for at least the prior 20 years. After six months of pitching DCF and getting no takers, I realized using a valuation method that’s arguably more rigorous is a futile effort unless the rest of the world will come around to this methodology.

    There can be a benefit in using a second method in terms of helping understand a stock’s or sector’s unique characteristics. For example, if you notice most stocks in a sector trade at a discount to the broader market on a P/E basis, you might discover they don’t generate much free cash flow and therefore look expensive on a free cash flow basis, which may justify the low P/Es. When a stock or sector moves from looking “expensive” to “cheap” (or vise versa) under two different methods, reconcile the difference.

  2. If there has been more than one valuation method used by the market in the past, identify:
    1. Why it changed (see examples below); and
    2. What catalyst(s) caused it to change; and
    3. What similar catalysts could cause investors to look at a new valuation method over your investment time horizon
  3. If the primary valuation method used by the market for a specific stock differs from its peer group, identify the justification
  4. Be reluctant to create a price target based entirely on a valuation method that’s not been widely used by the market in the past or at present (stocks rarely out- or under-perform due to the market changing to a previously-unused valuation method for that stock)
  5. Here are some of those limited times when valuation methods change, and therefore could be used to identify a mispriced stock:
    • Economic Cycles:
      • For some cyclical stocks, during periods when the market believes a peak in the economic cycle is near, analysts will value the stocks on “normalized earnings” because they know the next 12-month estimate is not likely sustainable
      • The U.S. banks were predominantly valued using P/B pre-2008 to being valued on their ability to get financing during the financial meltdown of 2008
      • During the 2008 downturn, North American telecom analysts were split on valuation methods, with some valuing stocks on EBITDA, while others were defensively using dividend yields. However, the real valuation differentiator should have been focused on their financial forecasts, specifically, each  company’s ability to refinance its debt
    • Unique Company- and Sector-Specific:
      • As Blackberry went from boom to bust, it was valued from P/E to P/S and then to P/tangible book
      • Investors shifted from P/E to FCF for Dillard’s, due in part to its strong FCF and possibly due to owning 75% of its own real-estate (which is unusual for a retailer)
      • Going back at least 20 years, when airlines have been earning a profit they are valued on a P/E basis but when they overbuild capacity (which occurs more often than the typical business cycle), they are valued on a P/S basis
      • When Liz Claiborne was at $4 it was being valued on price/sales and then as the market realized it could be turned around, valuation shifted to EV/EBITDA and the stock went to $10 (at which point it changed its name to Fifth & Pacific). The company then sold several divisions, and became Kate Spade, where the valuation method shifted to P/E. Because of the substantial ramp up in sales and margins in its new form, valuation changed again, to PEG.
    • When a company is being considered as a take-out candidate, the market may shift from a traditional valuation method such as P/E to using EV/EBITDA because the target company’s debt level becomes less important

This is the first in a three-part post. In my next entry, I’ll focus on the pros and cons of the most commonly-used valuation methods and in the last post provide a flow chart for selecting the optimal method.

AnalystSolutions has developed a workshop to cover the “T” of TIER™: Apply Practical Valuation Techniques for More Accurate Price Targets

This Best Practices Bulletin™ targets activity #3, “Make Accurate Stock Recommendations” within our GAMMA PI™ framework.

©AnalystSolutions LLC All rights reserved. James J. Valentine, CFA is author of Best Practices for Equity Research Analysts, founder of AnalystSolutions and was a top-ranked equity research analyst for ten consecutive years

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