Historical Predictive Power: Uncertain (cannot test directly due to computational limitations)
How it Relates to Returns: For companies with temporary shocks affecting the current price, it will correctly predict when stocks are undervalued. When shocks affecting the current price are permanent, it will incorrectly predict valuations.
What it is: A comparison of the current valuation of the stock relative to the same company’s historical valuation. Eg. If investors used to pay $15 for $1 of earnings but now only pay $10 for $1 of earnings, the company looks undervalued relative to its past.
How to use it: As a reality check and reason to dig deeper into the news. If a company is valued differently today than it was in the past, there must be a good reason. If you cannot find a convincing reason, consider making a purchase or sale.
Watch out for: Companies with extremely positive or negative recent news, or companies with earnings or sales that frequently fluctuate. For such companies, earnings and sales multiples are unreliable measurements of valuation.
The Central Correlation: Price and Earnings
Over the long run, price and earnings tend to be correlated. For example look at the S&P 500 price to earnings ratio, which treats the S&P 500 index like one giant conglomerate. It adds the market capitalizations of all of the companies in the index and divides that value by the sum of their net incomes. The result: one giant price to earnings ratio.1
With the exception of the tech crash of the early 2000s and the financial crisis in 2007-2008, the PE ratio rarely went above 25 or below 11 - meaning that the companies in the S&P 500 trade at prices around a constant multiple of earnings2. Over the same time, the level of the S&P 500 approximately doubled, so this is not the artifact of a flat market.
Similarly, individual companies will generally trade at some multiple of their earnings. The valuation from historical multiples attempts to help you find a reasonable value for those long term multiples. However, since both prices and earnings are fickle creatures, lets look at what can happen.
When Prices Change, Will Earnings?
Imagine that you are considering buying a car manufacturer called Bull Motors, which is trading at a PE ratio of 10 - near its historical average - with a Market Cap of $1 Billion. But imagine that the price suddenly goes up 50% over the course of 2 weeks with no accompanying change in earnings. Now the company is worth $1.5B and has a PE ratio is 15. What could have caused that?
One possibility is that Bull Motors recently achieved something amazing. For example, assume it won a contract to build 10% of the new taxi cabs in China. In this case, you can look at the value of the contract over the life of the business. If it is greater than $500 million, then Bull Motors may be undervalued. If the contract is only worth $100M, however, the market may have gotten ahead of itself. Bull Motors could very well be overpriced.
Another possibility is that you can find no news that would justify such a huge price move. In that situation, you should be very skeptical of the new price level.
In either case, the Valuation from Historical Multiples will show that the company is 50% over its historical average. This should serve as a warning to you. Look for good news in the past, and consider it carefully. There is no substitute for thought, but clear thinking will be rewarded.
Now imagine that Bear-Motors, a competitor with a similar history to Bull-Motors, falls from its PE ratio of 10 (and a company value of $1 Billion) to a PE ratio of 7.5 (a value of $750 Million). They recently lost a contract with the Japanese government when news came out their cars were unsafe. Again, it make sense to ask if the market valued this problem correctly. Further, if there is no such news news, you should be very skeptical that the lower price is justified.
In either case, the Valuation from Historical Multiples will show up as 25% under the historical average. Again, this should serve as a warning to you to look for reasons that the company may be facing issues.
When Earnings Change, Will Price?
Assume that Bull-Motors is selling near its historical average multiple of 10, but new earnings come out 50% higher than the previous year. Assume for a split second that price is unchanged. Should you buy?
If you answered, "It depends," then you're right. With no change in price and earnings up 50%, the PE ratio is now 6.67, but we need to know where this huge earnings jump came from. If it came from the sale of a one-time investment in another company, than we should not expect the high earnings to continue. Therefore, we probably do not think the stock is selling at a cheap price relative to its earnings. However, if the company has a new manufacturing process that saves huge costs, you may believe that the 50% earnings increase will continue. In the second case, trying to buy at the low multiple makes sense.
In either of these cases, our Valuation from Historical Multiples will show that the company is 33% under its historical multiple, and it should prompt you to look for more information.
Similarly, earnings can fall, and we need to ask ourselves: Is this a permanent decrease in earnings or something else?
The Key Takeaway - Look for the Reason
There is no simple way to explain price movements in the market. There is a constant stream of information which may or may not represent something that affects the company you plan to buy. However, if you see that prices or earnings deviate from history, by understanding the causes you are in a better position to find good deals.
The Valuation from Historical Multiples will help you to locate deviations, but you must supply the thought.
(1) Similar stories can be told for Price and Sales, our other historical multiple, but we use price and earnings only to illustrate more simply.
(2) More specifically, the value weighted average of S&P 500 companies trade around a constant multiple of value weighted earnings.