P/E Fair Valuations

Stocks are great long-term bargains when P/E ratios are low.

14x earnings is the long-term base fair-market valuation. It provides a stable central reference point off of which we can define cheap and expensive. Half of fair-value, or 7x earnings, is cheap and a great bargain.

Conversely 21x earnings is moving into the realm of expensive valuations. And double fair value, or 28x earnings, is bubble territory. Try to keep dwelling on the fact that $1 of earnings is $1 of earnings, totally fungible. So paying only $7 for that dollar of earnings is vastly superior than paying $28 for that same dollar. For long-term investors, the valuations at which they choose to buy is the single most important factor guiding the long-term success of their investments.

If I had to pick one metric for longer holding periods, it would be a low Price to Book. Beat the broader market by buying a diversified portfolio of low PB stocks (below the market median and average) and rotating them as need be after holding +/- a year.


What Is Fair Value Price?

1) First check if that company is worth valuating. A company worth valuating should have consistent shareholders' equity growth, EPS growth, sales growth, cash growth and better still, if you can find its ROC growth. All these figures should have more than 10% every year.

2) Once you found such company, get the average growth rate in shareholders' equity of the past 5 years or more.

3) Once you got the figure in step (2), use that figure to project it's EPS for the next 5 years (or whatever years you use in step 2).

4) Once you get the EPS in step (3), multiply that by the average PE of the last 5 years. Now, you get the estimated fair price of the stock in 5 years time.

5) Now let's say you want 15% returns/year for this stock from now to the next 5 years. Use the price obtained from step (4) and work backwards using 15%/year. Now you get the true price of the stock today.

6) Throw in a discount of 50% (margin of error) to the price you obtained in step (5). What is this price compare to the price of the stock that is trading now? If they are close, then you know that this stock is undervalued by 50%. Good bargain! Buy it!


Great Secular Bears

Great Bears start at high P/E ratios and low dividend yields. Then these key valuation metrics gradually declined throughout the bears. The problem with Great Bears is that they do not just drive stocks from overvalued to fair-valued, but they ultimately drive stocks all the way down to deeply undervalued levels. In valuation terms, the late 1974 cyclical-bear bottom happened near 8.3x earnings.

Great Bears last for 17 years and do a masterful job of stringing the bulls along. They are not an endless grind lower, but instead a series of periodic multi-year downlegs (cyclical bears) punctuated by spectacular multi-year cyclical bulls. This pattern gradually turns the screws to the bulls, continually providing them with just enough hope so they stay fully invested until the very end.

Secular bears are really long periods of time when the markets trade sideways on balance, huge cyclical bulls followed by devastating cyclical bears. This cycle continued over and over again. It is this sideways trading that slaughters even the bravest buy-and-hold investors in the end.