essays pieces of the puzzle
Thursday, September 9th, 2010
valuation special

Cisco (CSCO) is another of those high-quality stocks that seems to be on sale these days.  You’ll notice that I didn’t say the stock “is cheap,” but instead used the words “seems to be.”  That’s appropriate for this thematic edition of pix (the first such), in which each item touches on valuation, a process that is all about questions, not answers.

The chart above looks at two price/earnings ratios for CSCO.  The top clip shows the lofty trailing multiple afforded the stock during its early years, the truly astounding one awarded it when it was the icon of icons, and the subsequent decade spent unwinding those expectations and positions.  The bottom clip shows the forward P/E (of which Bloomberg’s history is relatively short).  That close-up look makes clear the nasty decline in valuation during the last few months.

We can argue about the best metrics and methods of valuation, but no matter the measure used, there has been a stunning loss of confidence in CSCO.  How much of it will be justified by subsequent fundamentals remains to be seen.  The challenge for the investor is the one that is ever-present:  Do you like the odds posted on the valuation board or not?  Why?  What is it about this horse and the market/economic racetrack that it will be running that makes you think that you’ll be rewarded by buying a ticket on it?  As always, you don’t have to play, but you can — if you have the available funds.  (Chart:  Bloomberg terminal.  Disclosure:  CSCO is held in managed accounts.)

valuation tools and trends

Yesterday, Barry Ritholtz commented on a couple of Wall Street Journal articles about the P/E ratio.  He rightly pointed out that, to continue my analogy above, the crowd sets the odds — and its moods create the long-term market cycles that we study and talk about so much.  Sorting out valuation is as daunting for the press as it is for investors, but articles should be clear about whether the subject is the process of valuation or what valuation levels might tell investors about the risks and opportunities available in the markets.  So, how about an article about valuation measures becoming less popular among investors because they are finding that trend-following strategies are “working”?  That’s a great topic.  How about one that explores the benefits and traps of simple valuation measures like P/Es versus more complex ones like DCF (discounted cash flow) models?  Definitely of interest.  Or maybe one that explores the fact that the prospects for subsequent returns are related to the general level of valuation at the time of purchase?  Such a basic concept is too often avoided in media accounts and can’t be repeated enough.  But to publish poorly-conceived mash-ups of this and that?  Worthless and even damaging.

price to fair value

The equity analysts at Morningstar arrive at a fair value price for each stock they cover, based upon detailed DCF models.  The firm’s key valuation metric, the ratio of market price to its judgment of fair value (P/FV), is used extensively in its research on individual stocks, groupings of stocks (including ETFs and indexes), and the market as a whole.  Look, for example, at its all-rated-stocks P/FV.  (For the best view, change the time frame to “max.”)  As with any source of information, it is important to understand the nature of the inputs and the methodology used by Morningstar to arrive at fair value, especially since its process differs from that of other firms.


You might say that Aswath Damodaran has written the book on valuation, but actually he’s written many of them, and lots of other stuff too.  He is Mr. Valuation and much of his work is available online.  His blog is worth following (but he posts infrequently); for a deep dive, his website offers an incomparable treasure trove of valuation information.

the equity risk premium

On his site, Damodaran offers regular updates related to the equity risk premium.  I’ve struggled with the notion, derivation, and application of the equity risk premium, which constitutes one element of the plug-the-number-in approach that characterizes much valuation work.   To the point, CXO Advisory offered a great, quick summary of a new paper on where the numbers come from and how they vary according to time and circumstance.

be careful with those valuations

“Erroneous assumptions can be disastrous.” — Peter Drucker.