The United States stock market is on fire. In fact, all three major stock indices are trading near their all-time highs. If any optimistic news breaks on the trade dispute with China, stocks are certain to blow past prior records.
That being said, many financial experts are warning that the market is overpriced. To reach this conclusion, many rely on valuations like forward price earnings (PE) ratios.
However, it is our experience that these conventional valuation strategies miss the mark. The truth is that business valuation methods are incredibly complex.
However, there is one indicator that does not lie and that is cash. Read on for a guide to understanding business valuation methods.
Price to Earnings Ratio
One of the most popular valuation metrics is PE ratios. Simply put, this compares a stock’s price against its earnings.
However, this method is flawed because earnings reports can be manipulated. To make earnings look better than they actually are, corporate accountants apply adjustments that are not transparent to the average investor.
For example, some accountants use rule changes to slide earnings to different reporting periods. While the business base remains unchanged, it gives investors the perception that earnings have increased.
Another major issue with PE ratios is that assets and liabilities are not included in the formula. The simplistic nature of the PE ratio glosses over companies with substantial operating cash flow on hand. It also does not place weight on companies with unacceptable levels of debt.
Lastly, statistical analysis disproves any correlation between earnings and value. Companies with high earnings per share (EPS) growth do not produce higher PE multiples.
Rely on Cash Instead
Several valuation methods rely on free cash flow instead. This is a better strategy as companies with cash on hand are healthier than those with massive debt.
One evaluation strategy is referred to as a discounted cash flow model (DCF). The DCF model is based on future cash flows. When the DCF value is higher than the share price, it means a buying opportunity is present.
It is important to use the DCF model only for companies that do not give a dividend. Companies that provide a dividend are certain to calculate a negative DCF value.
When a dividend is present, experts turn to free cash flow instead. This involves calculating the delta between operating cash flow and capital expenditures.
Another popular indicator is price-to-cash flow (P/CF). This calculation is simple like the PE ratio, however, uses operating cash flow per share instead of earnings.
What the P/CF ratio reveals is how much an investor is willing to pay for cash flow. Consider a company trading for $50 and having operating cash flow of $5 per share. For every dollar of cash flow, investors are amenable to paying $10 per share.
A Recap of Business Valuation Methods
Every investor has their own magical formula to evaluate stocks. Our advice is to express skepticism towards methods relying on earnings. Instead, the best approach in our experience is to review the company’s cash position.
If you enjoyed this article about different valuation methods, check out our corporate finance blog for other great content.