How to Tell When a Stock is Cheap/Expensive

You have probably heard the age-old stock market advice

to buy low and sell high,

but how do you know what is high and what is low in advance?

It simply isn’t that simple.

However, you can learn how to value a stock properly

with three different methods:

relative valuation using PE ratios, Discounted Cash Flow (DCF),

and a third option that falls somewhere in between.

1. Relative Valuation and Valuation Multiples

To apply relative valuation, you buy stocks when they

are cheaper than their historical averages

and/or when they are cheap compared to peers in the market.

To understand how to apply this,

one needs to understand valuation multiples.

It is not useful to say that a stock is expensive just

because it costs a lot of money per share.

Warren Buffett would say that price is what you pay,

value is what you get.

• Price-to-Earnings (PE) Ratio: If you buy a stock, you should be interested in how quickly you can recoup your investment. If Coca-Cola is at a price of $72 and earns $2.50 per share, it will take 28.8 years to recoup your investment. This is the PE ratio.
• Forward PE: Because PE is backward-looking, investors use the forward PE, which is the current price divided by analysts’ expectations for next year’s earnings.
• Historical Valuation: You need to know how much the stock usually costs. If Coca-Cola’s 10-year historical average is 23 times forward earnings, and its current price is 24 times, you wouldn’t want to buy it right now.
• Peer Comparisons: You must also know how much investors are willing to pay for similar companies in the market. If competitors trade at an average future PE of 21.3, and Coca-Cola is at 24, it stands to fall. Sometimes, doing peer comparisons reveals a competitor that is a much better investment opportunity.

The Margin of Safety

You do not want to buy a stock when its price

is exactly as high as its intrinsic value,

but you also do not want to buy it at 99% of its worth.

A margin of safety is necessary because valuation is an imprecise art.

The future is unpredictable, and investors make mistakes.

For stable businesses where you are highly confident

in your assumptions (like Coca-Cola),

you don’t need a huge margin of safety.

You might prefer to buy them at 40 cents on the dollar,

but paying closer to fair value is sometimes acceptable

for a dominant, longstanding business.

Limitations of Relative Value

If everything in an industry is completely overpriced

(like the dot-com bubble in 2000),

buying the “cheapest” stock in that sector

can still lead to massive losses.

Furthermore, assuming everything else

is equal when comparing PE multiples is dangerous;

sometimes, a company is cheap for a good reason

because it is underperforming.

2. Discounted Cash Flow (DCF) Analysis

Because valuation multiples can lead us astray,

we need a complementary valuation technique:

the Discounted Cash Flow analysis.

Warren Buffett asks three core questions

to determine intrinsic value:

1. How much cash are you going to get?
2. When are you going to get it?
3. How certain are you?

How Much Cash Are You Going to Get?

We use history as a proxy for the future,

but we must focus on free cash flow, not just earnings.

Free cash flow is cash from operations minus capital expenditures.

• Forecasting: In theory, we want to forecast cash flows from today until infinity. In practice, we forecast 10 years into the future and add a “terminal value” for years 11 to infinity.
• Growth Rates: Be careful not to be too optimistic. Very few large companies can compound their earnings at 15%. Use historical company growth and industry projections as reality checks.
• Terminal Value: Imagine you sell the business in year 10. To find out how much you could sell it for, you can apply an exit multiple (like a 10-year median Price to Free Cash Flow multiple) to year 10’s projected free cash flow.

When Are You Going to Get It?

Money today is worth more than money next year.

We use a discount rate to determine how much lower

we value future cash compared to today’s cash.

• If we use a 10% discount rate, we value money received next year at 90 cents on the dollar.
• A solid benchmark for a discount rate is the 10-year government Treasury yield plus 3 percentage points.

How Certain Are You?

Some businesses have a lousy past record

and a bright future;

value investors typically miss those opportunities

because they demand certainty.

• Look for businesses that are predictable and not susceptible to change.
• Change is often viewed as a threat to the investment process rather than an opportunity. Finding a business that will likely look exactly the same in 10 or 20 years gives you much more confidence in predicting its cash flows.

3. Financial Projections and Return Calculations

The third valuation option involves plugging in sales,

operating margins, interest, tax rates, buybacks, dividends,

and a valuation multiple into

a calculation tool to forecast a stock’s future value.

• By inputting realistic assumptions based on historical and forecasted data, you can project what a stock will be worth by a specific future date (e.g., December 2029).
• This model allows you to calculate the expected annual return percentage.
• You then compare this expected annual return to your required discount rate to see if you have a sufficient margin of safety.

There is no single easy method that can be mechanically applied.

Stock valuation is a game played with multiple techniques,

multiple models, and a lot of experience.

It is always a good idea to triangulate

and find a company that looks like a phenomenal investment,

no matter which valuation lens you choose.