Hope all is well. Recently, a very interesting article about an expeditious approach to determine the fair value of stock was published. I thought about it for a while and said to myself, it is worth summarizing for this month’s blog. The credit for this blog must therefore go to Chuck Carnevale of Fast Graphs who happens to be a consistent contributor to Seeking Alpha.
The basic premise of his article suggested that shareholders might know the price of the stock but not its worth and since there is no preciseness in calculating stock value, it creates much stress for investors. He presented a fact pattern regarding Citigroup that showed that over the last 20 years, earnings performance ultimately translated into stock value. At its essence, the fair value of common stock relates to what you are paying to buy a current dollar’s worth of the company’s earnings. If that is the assumption one is working from, then fair value is simply the current earnings yield that the investor is receiving on their capital. The most common PE ratio that depicts fair value for most companies is 15, which represents a current earnings yield of 6% to 7%. As a result, if you utilize a PE ratio of 15 as a fair value guide for most companies, you can be confident that you are investing in them at a sound valuation.
Mr. Carnevale concluded by suggesting that if a stock is trading at a PE ratio above 15, you can assume that it is overvalued. For example, if a blue-chip stock is going for 16, 17 or 18 times earnings, this would simply mean that your future return will be lower than it would have been had you only paid the PE ratio of 15. This might mean that you will earn a return that is lower than you deserve, but perhaps a return that is earned at lower risk.
Until next time……………………….