What Is A Stock Worth?

Implications for Equity Investing at Historic Valuations

What Is A Stock Worth

“What is a stock worth?” This seemingly simple question opens up a Pandora’s Box. With billions of shares of stocks traded worldwide every day answering this question might seem like an impossible task. To bring clarity to a complex question, sometimes it is best to return to the basics.

 

The legendary investor Benjamin Graham, once said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

 

This quote is an excellent starting point for determining “What is a stock worth?” The price of a stock is how investors “vote” for a stock in the short run. The earnings of a stock are how investors “weigh” a stock in the long run. Our discussion starts with earnings.

The Price You Pay vs. The Value You Receive

When US equity markets are pushing ever higher, investors naturally begin wondering “what are the best stocks to invest in right now?”   But, as with purchasing other goods, before investors consider what stock to invest in, they should consider what a desired stock is worth.

 

In an age of high-frequency trading and “meme” stocks, it is easy to forget the fundamentals; that a stock represents ownership in a company. Therefore, the value of a stock should be what the company will earn for its owners. Theoretically, the price of a stock should equal its value, but theory and reality seldom agree.

 

Determining the price of a stock is easy; anyone with access to the internet can immediately learn the price of a stock. Determining value is much more difficult because it requires forecasting the earnings of a company out into the distant future.

 

One of the most frequently used tools used by analysts to reconcile these two measures is known as the “price-earnings ratio.” At its core, it is a very simple concept[1], and is literally the current price of a stock, divided by its earnings:

Price Earnings Ratio

This simple metric allows us to gauge the sentiment for a stock. Consider the following example:

Sentiment For A Stock

[1] The devil is in the details when it comes to calculating earnings. Some people use the most recent quarter or year’s earnings. Another approach is to try to forecast earnings out in to the future and produce a “forward-looking” earnings estimate. Others will adjust a company’s earnings for accounting factors like interest, taxes, depreciation and amortization. Suffice to say, determining the earnings for the P/E ratio’s denominator is the hard part.

 

Stock A has a high price-earnings ratio of 25. That means investors are willing to pay a high price today for a company’s future earnings. In other words, investors are bullish on a Stock A. Conversely, Stock B has a low price-earnings ratio, which implies investors are not very excited about a company’s earnings. They aren’t very willing to pay a high price for that company B’s stock- i.e., a bearish outlook.

 

Does this mean Stock B is a bad investment? Not necessarily. Some investors look at the above numbers and see “value” in Stock B. In the eyes of a value investor, both stocks are offering up $10 of earnings per share, but Stock B allows you access to those earnings for a much cheaper price- $100 vs. $250.

 

Beauty, or in this case a good P/E ratio,  is in the eye of the beholder. Some would argue Stock A is the better investment, others would favor Stock B. This debate is one of the fundamental conflicts in investing, the difference between “growth” and “value” investing, respectively.

 

We can also view the P/E ratio from a time standpoint. The P/E ratio tells us how many years of earnings we are purchasing at today’s stock price.

  • If Stock A has earnings of $10 per share and the price is $250, the P/E ratio of 25 implies that today investors are paying for the next 25 years of earnings.
  • Alternatively, Stock B’s P/E ratio of 10 means it will only take ten years of earnings in order to recoup the price of the stock today[2].

 

Today, many stocks are trading at P/E multiples of greater than 50, meaning investors are paying for earnings all the way out to the year 2071, or longer!

Implications for Buying Stock at a High Valuation

 

We can also get a “big picture” view of the market by aggregating the P/E ratios of many stocks in the market. The Dow Jones Industrial Average rolls up 30 stocks; the broader S&P 500 encapsulates 500 stocks in the U.S. market. By averaging the P/E ratios for these indices, we can get a feel for the aggregate bullish or bearish sentiment for the overall market.

 

The graph below illustrates one of the more popular P/E ratios, the Shiller P/E ratio, going back almost 150 years. The current level of the P/E ratio is 38.6. In other words, it would take almost 40 years of earnings to justify today’s prices. Unless earnings improve dramatically, investors buying at today’s high prices won’t “break even” until the year 2060.

 

Shiller Price Earnings Ratio

Source: https://www.multpl.com/shiller-pe

[2] NOTE: there are many variables to consider with forecasted earnings. A company can do better or worse than expected, and their earnings can improve or deteriorate. Inflation may eat away at the value of future earnings. Any number of things can alter earnings 10, 20, or 30 years into the future.

 

Today we are at the second-highest valuation levels in history.

 

Current market valuations exceed levels seen just before the Black Tuesday market crash of 1929 and the Great Depression. The only time in history the U.S. market has exceeded these levels was during the “dot-com bubble” of the late 1990’s, just before the S&P 500 entered a three-year bear market and lost nearly half its value. Avoiding such a large loss is important both emotionally and mathematically to investors’’ long-term success.

Does Stock Valuation Matter?

There exists an alternative answer to the question, “What is a stock worth?” Some people would answer, “Whatever someone is willing to pay for it.”

 

This is the “voting machine” dynamic Benjamin Graham described. Under this framework, a company, the business it is in, the earnings of that company, and the company’s fundamental value are all irrelevant—sentiment and momentum drive prices, not fundamentals.

 

In this framework, the only thing that matters is the stock’s price. The price of a stock is essentially a popularity contest. This gives way to the Fear of Missing Out (FOMO) driving investors into stocks showing upward momentum.

 

It is this mindset that recently drove “meme” stocks like AMC and Gamestop to ridiculous highs. A generation ago, it was the dot-com stocks like Pets.com and Webvan that were bid up to stratospheric heights. While the names might have changed, the story remains the same.

 

The inherent weakness and eventual undoing of these no-earnings stocks is baked into the statement: “A stock is worth whatever someone is willing to pay for it.” If that statement is true, what happens if no one is willing to pay much for the stock in question? If there are no buyers, then a stock is worthless.

 

This leads to what is known as the “greater fool” theory. If someone owns a stock with no intrinsic value, the only way that person is going to make any money is to hope someone comes along who is willing to pay a higher price for a worthless stock; i.e., the greater fool.

 

So where does that leave us today?

An Alternative Way to Buy Stocks at High Valuations

With equity markets at all-time highs, we at Swan Global Investments are concerned about the valuation levels of U.S. equity markets. As investors seek out the best stocks to buy now and consider earnings, the “weighing machine” metrics like the P/E ratio indicate stocks are very expensive at the moment.

 

If one doesn’t care about earnings, the only justification for buying stocks is “because stocks are up”. If that’s the case, then one runs the risk of being “the greater fool.” Like a game of musical chairs, everyone will be scrambling in a panic once the music stops.

 

But there is another way: hedged equity.

 

Swan believes downside risk is ever-present in the market but is especially relevant today. For almost 25 years our investment philosophy has been to remain “Always Invested, Always Hedged.” Our philosophy is applied to a range of hedged equity funds and strategies that invest in the markets in order to participate in stock market gains. But we also always hedge our investments with put options that are designed to increase in value during market sell-offs.

 

No one knows when stocks might eventually sell off. But Swan and investors utilizing our hedged equity approach are prepared for that day.

Swan Resources & Education

Our portfolio managers and analysts are dedicated to creating relevant, educational Articles, Podcasts, White Papers, Videos, and more.

About the Author

Marc OdoCFA®, FRM®, CAIA®CIPM®CFP®, Client Portfolio Manager, is responsible for helping clients and prospects gain a detailed understanding of Swan’s Defined Risk Strategy, including how it fits into an overall investment strategy. Formerly Marc was the Director of Research for 11 years at Zephyr Associates.

Swan Resources & Education

Our portfolio managers and analysts are dedicated to creating relevant, educational Articles, Podcasts, White Papers, Videos, and more.

Important Disclosures:

Swan Global Investments, LLC is a SEC registered Investment Advisor that specializes in managing money using the proprietary Defined Risk Strategy (“DRS”). SEC registration does not denote any special training or qualification conferred by the SEC. Swan offers and manages the DRS for investors including individuals, institutions and other investment advisor firms. Any historical numbers, awards and recognitions presented are based on the performance of a (GIPS®) composite, Swan’s DRS Select Composite, which includes nonqualified discretionary accounts invested in since inception, July 1997, and are net of fees and expenses. The Swan Defined Risk Strategy Select Composite demonstrates the performance of non-qualified assets managed by Swan Global Investments, LLC since inception. It includes discretionary individual accounts whose account holders seek the upside potential of owning stock, and the desire to eliminate most of the risk associated with owning stock. The Composite relies on LEAPS and other options to manage this risk. Individual accounts own S&P 500 exchange traded funds and LEAPS associated with the exchange traded funds as well as multiple other option spreads that represent other indices that are widely traded. The Defined Risk Strategy was designed to protect investors from substantial market declines, provide income in flat or choppy markets, and to benefit from market appreciation. Stock and options are the primary components of the strategy. Swan claims compliance with the Global Investment Performance Standards (GIPS®). All data used herein; including the statistical information, verification and performance reports are available upon request. The S&P 500 Index is a market cap weighted index of 500 widely held stocks often used as a proxy for the overall U.S. equity market. Indexes are unmanaged and have no fees or expenses. An investment cannot be made directly in an index. Swan’s investments may consist of securities which vary significantly from those in the benchmark indexes listed above and performance calculation methods may not be entirely comparable.

 

All Swan products utilize the Defined Risk Strategy (“DRS”), but may vary by asset class, regulatory offering type, etc. Accordingly, all Swan DRS product offerings will have different performance results and comparing results among the Swan products and composites may be of limited use. Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there are no assurances that it will match or outperform any benchmark. Therefore, comparing results shown to those of such indexes may be of limited use. The adviser’s dependence on its DRS process and judgments about the attractiveness, value and potential appreciation of ETFs and options in which the adviser invests or writes may prove to be incorrect and may not produce the desired results. There is no guarantee any investment or the DRS will meet its objectives. All investments involve the risk of potential investment losses as well as the potential for investment gains. This analysis is not a guarantee or indication of future performance. Prior performance is not a guarantee of future results and there can be no assurance, and investors should not assume, that future performance will be comparable to past performance. All investment strategies have the potential for profit or loss. Further information is available upon request by contacting the company directly at 970.382.8901 or visit swanglobalinvestments.com. 202-SGI-081621