*Originally posted on September 13th, 2015*

This post will show how I calculate valuation, but more importantly, why it’s paramount to buy a business when fairly valued. Buying a high quality business is important, but you don’t want it at any price. A high quality business can be a bad investment if one pays too much for it. Valuation can be calculated based on a company’s intrinsic value.

However, calculating the present intrinsic value is just half of the equation. One must consider estimated earnings as well, to have an idea of what the intrinsic value will be. Since forecasting earnings involve the future, it can’t be precise, since no one knows what will happen for sure. It doesn’t mean it’s a random guess either. The key is that it doesn’t have to be precise. Market consensus and corporate guidance can give a good idea of what earnings are estimated to be – and therefore, how it should affect total return. One can also measure a degree of certainty by looking how accurate analysts have been with estimates. A company with a good score of meeting analysts estimates gives a good comfort for estimates to remain accurate, as it indicates that the business is predictable and analysts understand them well.

Stock prices in the short run can be driven by strong emotions such as fear and greed. The intrinsic value of a business is driven by fundamentals and can be calculated within a reasonable degree of certainty. Once this calculation is made, sound investing decisions can be made and implemented.

Continuing the exercise with BlackRock, we can see that stock price (line in black) follows earnings (line in orange). That also shows how price can be volatile. The blue line shows the historical P/E that the company has been trading for the analyzed period – which is normally considered as the fairly valued P/E to be used for this company.

For example, BlackRock was overvalued at the end of 2009. And that can be calculated. See how the stock price was trading above its intrinsic value. Had one bought in 2009, the annualized ROR would be 6.89%, which is an ugly total return for that period (the index alone was almost doubled, annualized).

However, had one purchased when it was fairly valued (it can be calculated), in this case just a few months later, the annualized ROR would be much higher, at 12%, almost double annualized by simply buying it when fairly valued. It would also give a better cushion if fundamentals suddenly deteriorate and one has to sell it eventually, because this would have been purchased at a lower price when bought when it was fairly valued. Future earnings is not in our control, but valuation is – that’s a risk that we can mitigate. So buying when fairly valued serves 2 purposes.

Since any company has different growth stages during its lifetime, I like to plot a 5-year timeframe, made of the last 3 years + the estimated 2 years. That gives a good idea of how BlackRock is presently undervalued:

BlackRock’s normalized P/E for that period is 16.9, and since earnings growth rate for that period is 13.4%, the intrinsic value is calculated through an extrapolation of Graham and Lynch’s formula. Estimated growth for this year (4%) and next year (11%) is lower than the earnings growth rate for the last 3 years (13.3%), so I’d consider the P/E 15 (Graham’s P/E for fair valuation) the fair valuation for this stock, simply going by the principle that there’s no justification for this company to trade at a premium P/E (16.7), if growth is slowing down. It made sense a few years ago, when growth was higher, but it makes less sense now. Therefore, considering this year’s estimated earnings of $20.08, my buy price for this stock is $301.18 – so now is a good time to buy it.

From an earnings estimated perspective, I antecipate an annualized ROR over 14% by buying it today, by end of 2017.

This graph shows that the historical P/E for the period that I used (last 3 years) is actually the lowest P/E from all past periods. That means, this company typically trades at a higher P/E – which represents the potential higher return, the current calculation is actually very conservative.

Lastly, I just want to finish this post giving 2 examples of how buying an overvalued company can be detrimental to total return. See Wal-Mart below, if one purchased it 15 years ago, when it was overvalued (this was not even the peak price, one could have done worse). In 15 years, annualized total return was a dismal 2.1%. Many might think Wal-Mart is a lousy business to invest, but the culprit here was actually high valuation. Price follows earnings, so it was a matter of time for that to happen.

A more dramatic example is Cisco. Terrific business, very strong earnings growth. But see the damage when one doesn’t take valuation into consideration. Cisco highest price was $77. After it dropped 50% from the peak, one must think this is a great bargain. So I consider the purchase at $38.25, done 15-years ago. Still today, one wouldn’t have recovered their money, regardless of being a fantastic business with an annualized earnings growth of 11.4 for 15-years. This is the best example of how a great business can be a terrible investment if one doesn’t take valuation into consideration – regardless of how great the business earnings go.

Earnings and valuation are the main drivers of total return, and both can be calculated with a certain degree of accuracy. Buying an undervalued company means buying a company that is not being loved by the market. If one understands that this is a long term investing and stay put, monitoring earnings, these will turn out to be great opportunities.

Hi Rod,

From the above:

“I’d consider the P/E 15 (Graham’s P/E for fair valuation) the fair valuation for this stock”

Is this something that fastgraphs can calculate for us? If not, what do you use to calculate it?

Also, the graphs you feature above to calculate fair valuation, is it relatively easy to come up with those when we use fastgraphs?

Ignore this question, it’s answered in your FAQ.