I keep coming back to a great book that I bought a few weeks ago, and that I finished in just a few days. The book is the fifth edition of Stephen Penman’s Financial Statement Analysis and Security Valuation. I highly recommend this book to anyone who wants to learn more about financial statement analysis and security analysis.
In the first chapter Penman shares a few tenets, or “guiding principles,” that he keeps coming back to throughout the whole book. These guiding principles aren’t really anything close to unknown to many of you who have already read a lot about investing and how to approach the issue of analyzing, valuing and buying different kinds of businesses. Anyway, I thought I’d share them here, because they are still sound principles, and as with all sound principles they are worth remembering… and sharing. Keep them close in mind when venturing out into the market space.
Tenets of Sound Fundamental Analysis
As we proceed through the book, we will appeal to a number of guiding principles. Here is some of the wisdom, distilled from practice of fundamental analysis over the years:
1. One does not buy a stock, one buys a business.
2. When buying a business, know the business.
3. Value depends on the business model, the strategy.
4. Good firms can be bad buys.
5. Price is what you pay, value is what you get.
6. Part of the risk in investing is the risk of paying too much for a stock.
7. Ignore information at your peril.
8. Don’t mix what you know with speculation.
9. Anchor a valuation on what you know rather than speculation.
10. Beware of paying too much for growth.
11. When calculating value to challenge price, beware of using price in the calculation.
12. Stick to your beliefs and be patient; prices gravitate to fundamentals, but that can take some time.
Beware of Paying Too Much for Growth
A P/E ratio indicates the market’s expectation of future earnings growth (as we will see explicitly in later chapters). A P/E of 88 for Dell is high by any standard, so the fundamentalist questions whether the market is forecasting too much earnings growth. Point 10 warns us against getting too excited—too speculative—about future growth. Fundamentalists see speculation about growth as one of the prime reasons for the overpricing of stocks and the emergence of price bubbles. A valuation method needs to build in protection against paying too much for growth. A sound valuation method challenges the market’s speculation about growth.
When Calculating Value to Challenge Price, Beware of Using Price in the Calculation
Price is what you pay and value is what you get. So Point 11 warns against referring to the market price when you are calculating value. If you do so, you are clearly being circular and have ruined the ability of your analysis to challenge prices. Yet analysts allow prices to enter in subtle ways. An analyst who increases her earnings forecast because stock prices have increased—and then applies a valuation multiple to those earnings—commits that error. That is so easy to do when there is excitement about a stock, for there is a temptation to justify the price. But the analyst may be joining a chain letter.
With the launch of iPad, when the shares of Apple Inc. traded at $380, an analyst forecast earnings per share for the firm of $28.82 for fiscal year 2011, considerably higher than for other analysts. This is fair enough, if the analyst can justify the number. But the analyst also published a price target of $548 per share and, accordingly, issued a buy recommendation. To get this price, the analyst multiplied his 2011 earnings estimate by Apple’s average P/E over the last three years of 19. You see the problem. The analyst is pricing earnings on the basis of the market’s pricing of earnings, but if that pricing is incorrect he is building mispricing into the calculation. He used price to challenge price rather than value to challenge price. And he compounded the speculation in a high forecast with speculation in the market price. If a P/E of 19 represents a mispricing, he contributed to the perpetuation of the mispricing. No wonder bubbles form. The fundamentalist takes care to apply methods that establish the intrinsic P/E ratio without reference to market prices.