What does cheap really mean when it comes to stocks?
At the time of writing the S&P500 is down 22% YTD with many thinking we are only about halfway through the pain. Considering the magnitude of the bubble we’re exiting with almost every single asset class participating, worldwide geopolitical tensions and a looming energy crisis; it’s hard not to share the view. The thing to remember is that bear markets/crises bring opportunities. Many of the stocks that have occupied watchlists while investors wait for more reasonable valuations are going to finally become reasonable and in some cases, become really cheap. But what does cheap really even mean? There are so many metrics and techniques out there to value stocks, from Discounted Cash Flow (DCF) models to ratios like Price to Earnings (P/E) or free cash flow (P/FCF), price to sales (P/S) and even price to book value (P/B). Which metrics matter? What’s the best technique?
Let me start off by saying people get way too caught up looking at a few key metrics and often miss the bigger picture. Often an investor may do a screen looking for stocks with low P/E. There’s a few problems with this and one can read an awesome paper about it here. That metric is also based on last year’s earnings. So, something may be cheap based on last year’s earnings, but it might be cheap because people don’t think it’s sustainable, or it may not have any growth. You might decide to buy it, but then you own a stock with a lot of downside risk and almost no upside. Remember the name of the game is risk/reward. Your job as an investor is to get paid as much as you can for taking on as little risk as you can. You want to find trades that are heavily right tail skewed.
The key to money management. It's making a lot of money when you are right, and minimizing it when you're wrong.
- Stanley Druckenmiller
There is also DCF models. But, the problem with solely relying on those are they are extremely sensitive to discount rates and terminal growth rates. Why should an investor with a finite amount of time spend so much of it on a model when a 200Bp change in discount rate could lead to a 25%+ change in the output price? Considering bonds (the 10Y treasury bond yield is a common input in the discount rate) are trading like crypto coins at the time of writing, it makes sense to be skeptical of a technique whose outputs can vary so much on how bonds are trading.
So these popular methods are bad on their own, but what about together? I believe there is two main factors to stock price appreciation: 1) multiple expansion and 2) earnings growth. By creating a model, forecasting future earnings and using that model in conjunction with appropriate multiples, an investor will have a more complete understanding of the potential multiple expansion or earnings growth, and thus a better understanding of the value of the company.