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Price and Value pp 317–364Cite as

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Assessments and Qualifications

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Abstract

The best and most consistent results for most valuation applications are (still) obtained from the traditional Price-to-Earnings Multiple. It benefits from the immediacy, completeness, and actionable realism of the market component (“Price”), paired with the least problematic constituents of the company’s financial statements (income statement components like “Earnings” or “Cash Flow”). The P/E, in its several versions, triangulates the intrinsic value of the enterprise with greater effectiveness than Book, Model, or Market alone and is superior to the other triangulating perspectives (Price-to-Book and Return-on-Assets).

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Notes

  1. 1.

    “Forward earnings perform the best” (Jing Liu, Doron Nissim and Jacob Thomas, “Equity Valuation Using Multiples,” Journal of Accounting Research, Vol. 40, No. 1 (March 2002), pp. 135–172).

  2. 2.

    Joseph Davis, Roger Aliaga-Díaz, and Charles Thomas, “Forecasting Stock Returns: What Signals Matter, and What Do They Say Now?” Vanguard Research, October 2012.

  3. 3.

    Joseph Davis, Roger Aliaga-Díaz, and Charles Thomas, “Forecasting Stock Returns: What Signals Matter, and What Do They Say Now?” Vanguard Research, October 2012. Reproduced by permission of Vanguard.

  4. 4.

    Jeremy Siegel calls the CAPE version of P/E “one of the best forecasting models for long-term stock returns” based on an R2 of 35% (“The Shiller CAPE Ratio: A New Look,” Financial Analysts Journal, Vol. 72., No. 3 (May/June 2016), pp. 41–50. “Best,” I suppose, is best when it’s all you’ve got.

  5. 5.

    Morgan Stanley Quantitative Equity Research, Global Factor Guide (November 5, 2019)

  6. 6.

    Eero Patari and Timo Leivo, “Persistence in Relative Valuation Difference between Value and Glamour Stocks: The Finnish Experience,” Banking and Finance Letters, Vol. 2, No. 3, pp. 319–324.

  7. 7.

    Mark T. Bradshaw, Michael S. Drake, James N. Myers, and Linda A. Myers, “A re-examination of analysts’ superiority over time-series forecasts of annual earnings,” Review of Accounting Studies, Vol. 17 (2012), pp. 944–968.

  8. 8.

    Jing Liu, Doron Nissim, and Jacob Thomas, “Equity Valuation Using Multiples,” Journal of Accounting Research, Vol. 40, No. 1 (March 2002), pp. 135–172.

  9. 9.

    Andreas Schreiner, “Equity Valuation Using Multiples: An Empirical Investigation,” Doctoral Dissertation, the University of St. Gallen Graduate School of Business Administration, 2007.

  10. 10.

    Javier Estrada, “Multiples, Forecasting, and Asset Allocation,” Journal of Applied Corporate Finance, Vol 27, No. 3 (Summer 2015), pp. 144–151.

    Joseph Davis, Roger Aliaga-Díaz, and Charles Thomas, “Forecasting Stock Returns: What Signals Matter, and What Do They Say Now?” Vanguard Research, October 2012.

    Clifford Asness, “Fight the Fed Model,” Journal of Portfolio Management, Vol. 30, No. 1 (Fall 2003), pp. 11–24.

    Savita Subramanian, “2017 – The Year Ahead: Euphoria or Fiscal Fizzle,” Equity and Quant Strategy, Bank of America/Merrill Lynch, November 22, 2016.

  11. 11.

    Mark Bradshaw, “The Use of Target Prices to Justify Sell-Side Analysts’ Stock Recommendations,” Accounting Horizons, Vol. 16, No. 1 (March 2002), pp. 27–41.

  12. 12.

    Data taken from Mark Bradshaw, “The Use of Target Prices to Justify Sell-Side Analysts’ Stock Recommendations,” Accounting Horizons, Vol. 16, No. 1 (March 2002), pp. 27–41.

  13. 13.

    That is, Generally Accepted Accounting Principles – short-hand for accounting that is conducted according to the recognized rules of the profession, and regulated by the Financial Accounting Standards Board.

  14. 14.

    Vito Racanelli, “Should Investors Still Mind the GAAP when it Comes to Earnings,” Barron’s, February 26, 2018

  15. 15.

    On “Street Earnings” – a version of non-GAAP earnings – see the next section.

  16. 16.

    Frank Heflin, Charles Hsu, and Qinglu Jin, “Accounting conservatism and Street earnings,” Review of Accounting Studies, Vol. 20 (2015) pp. 674-709

  17. 17.

    Martin Peers, “Investors Should Focus on Apple’s Core,” The Wall Street Journal, September 24, 2009. Also Michael Rapoport, Yukare Iwatani Kane, and Ben Worthen, “U.S. Accounting to Aid Tech Firms,” The Wall Street Journal, September 24, 2009.

  18. 18.

    Jo Craven McGinty, “Results May Vary: Why Companies’ Earnings Reports Differ,” The Wall Street Journal, April 25, 2015.

  19. 19.

    Mark Bradshaw and Richard Sloan, “GAAP versus The Street: An Empirical Assessment of Two Alternative Definitions of Earnings,” Journal of Accounting Research, Vol. 40, No. 1 (March 2002), pp. 41–66.

  20. 20.

    Jo Craven McGinty, “Results May Vary: Why Companies’ Earnings Reports Differ,” The Wall Street Journal, April 25, 2015.

  21. 21.

    Jo Craven McGinty, “Results May Vary: Why Companies’ Earnings Reports Differ,” The Wall Street Journal, April 25, 2015. Reproduced by permission from The Wall Street Journal.

  22. 22.

    Chih-Ying Chen, “Do analysts and investors fully understand the persistence of the items excluded from Street earnings?” Review of Accounting Studies, Vol. 15 (2010), pp 32–69.

  23. 23.

    Philip Berger, “Discussion of ‘Are Investors Misled by “Pro Form” Earnings,’” Contemporary Accounting Research, Vol. 22, No. 4 (Winter 2005), pp. 965–976.

  24. 24.

    Jo Craven McGinty, “Results May Vary: Why Companies’ Earnings Reports Differ,” The Wall Street Journal, April 25, 2015.

  25. 25.

    Yhlas Sovbetov, “How IFRS Affects Value Relevance and Key Financial Indicators? Evidence from the UK,” International Review of Accounting, Banking and Finance, Vol. 7, No. 1 (Spring 2015), pp. 73–96.

  26. 26.

    Tatyana Shumsky, “Updated Accounting Rules Reverberate,” The Wall Street Journal, June 13, 2018.

  27. 27.

    Warren Buffett, 2017 Annual Letter to Berkshire Hathaway Shareholders. See also Donald E. Graham, “I Can’t See Berkshire’s Bottom Line,” The Wall Street Journal, November 8, 2018.

  28. 28.

    SFAS 123 (1995).

  29. 29.

    FAS 157 (2007).

  30. 30.

    FAS 142 (2001).

  31. 31.

    Laurence Siegel, “CAPMing the CAPE: Shiller-Siegel Shootout at then Q Group Corral, Part 2,” available online at https://larrysiegeldotorg.files.wordpress.com/2016/09/siegel_capming-the-cape_2016_09_08.pdf

  32. 32.

    John Markoff, “Microsoft’s Accounting Under Scrutiny,” July 1, 1999.

  33. 33.

    Justin Fox, “Learn to Play the Earnings Game,” Fortune, March 31, 1997.

  34. 34.

    Justin Fox, “Learn to Play the Earnings Game,” Fortune, March 31, 1997.

  35. 35.

    Rebecca Buckman, “Microsoft, SEC Settle Probe Into Earnings Misstatements,” The Wall Street Journal, June 4, 2002. A few more details: “Microsoft Corp. agreed to settle Securities and Exchange Commission civil allegations the software company misstated its earnings during certain periods during the 1990s by illegally maintaining different ‘reserve’ accounts for such expenses as marketing and obsolete inventory, the SEC said…. The case is regarded as somewhat unusual, because it involved a cash-rich company setting aside reserves that in some cases understated quarterly income, rather than inflating it. Such techniques can have the effect of smoothing out quarterly results and providing better predictability to Wall Street…. The SEC…said ‘senior Microsoft financial personnel’ frequently added to the estimates for reserve accounts – in effect increasing expenses – without adequate analysis.”

  36. 36.

    “Six Muddles About Buybacks,” The Economist, June 2, 2018.

  37. 37.

    Lawrence Strauss, “Stock Dividends Aren’t What They Used to Be,” Barron’s, April 29, 2019.

  38. 38.

    Matt Phillips, “Buybacks Dip Could factor Into Sell-Off,” The New York Times, October 12, 2018.

  39. 39.

    Michael Rapoport and Theo Francis, “Buybacks Dress Up Profits,” The Wall Street Journal, September 24, 2018.

  40. 40.

    E. S. Browning, “Surge in Buybacks Stirs Up Worries,” The Wall Street Journal, November 23, 2015.

  41. 41.

    Rolfe Winkler, “Microsoft Buys Back Earnings Growth,” The Wall Street Journal, September 18, 2013.

  42. 42.

    E. S. Browning, “Surge in Buybacks Stirs Up Worries,” The Wall Street Journal, November 23, 2015.

  43. 43.

    Adapted from Rolfe Winkler, “Microsoft Buys Back Earnings Growth,” The Wall Street Journal, September 18, 2013

  44. 44.

    To me, this is one of the most intriguing unanswered questions related to valuation in general and the significance of market multiples in particular. I am not aware of any studies that have really focused on this issue.

  45. 45.

    Allison Nathan and David Groman, “Buyback Realities,” Goldman Sachs Global Macro Research, Issue 77, April 11, 2019.

  46. 46.

    Jessica Menton, “Volatility Unlikely to Derail Buybacks,” The Wall Street Journal, May 17, 2019; the report referenced in this article is by Ed Clissold, Ned Davis Research, May 2019.

  47. 47.

    Corrie Driebusch, “Volatility Sets Up a Boom in Buybacks,” The Wall Street Journal, October 24, 2018; Matt Phillips, “Buybacks Dip Could factor Into Sell-Off,” The New York Times, October 12, 2018.

  48. 48.

    Matt Phillips, “Buybacks Dip Could factor Into Sell-Off,” The New York Times, October 12, 2018; Corrie Driebusch, “Volatility Sets Up a Boom in Buybacks,” The Wall Street Journal, October 24, 2018.

  49. 49.

    Allison Nathan and David Groman, “Buyback Realities,” Goldman Sachs Global Macro Research, Issue 77, April 11, 2019.

  50. 50.

    Thomas Gilbert and Christopher Hrdlicka, “The Hedge Fund That Makes iPhones,” The Wall Street Journal, August 27, 2018.

  51. 51.

    In their research, Gilbert, Hrdlicka, et al. applied several tests for liquidity, relying on reporting under FASB 157 (Fair Value Measurements). They classified 74% of non-Treasury government debt, 90% of corporate debt, and 97% of asset- and mortgage-backed securities as illiquid (Ran Duchin, Thomas Gilbert, Jarrad Harford, and Christopher Hrdlicka, “Precautionary Savings with Risk Assets: When Cash is Not Cash,” The Journal of Finance, Vol. 72, No. 2 (April 2017), pp. 793–852).

  52. 52.

    In an earlier version of the paper, the estimate of the discount was higher: “The value of risky reserves is 23.2-29.7% lower than the value of safe reserves.” (Ran Duchin, Thomas Gilbert, Jarrad Harford, and Christopher Hrdlicka, “Precautionary Savings with Risky Assets: When Cash Is Not Cash,” July 2014).

  53. 53.

    Thomas Gilbert and Christopher Hrdlicka, “The Hedge Fund That Makes iPhones,” The Wall Street Journal, August 27, 2018.

  54. 54.

    John Jannarone and Sara Silver, “Cash (Kept at Home) is King,” The Wall Street Journal, January 14, 2009.

  55. 55.

    Thomas Gilbert and Christopher Hrdlicka, “The Hedge Fund That Makes iPhones,” The Wall Street Journal, August 27, 2018. See

  56. 56.

    Vito Racanelli, “Should Investors Still Mind the GAAP when it Comes to Earnings,” Barron’s, February 26, 2018.

  57. 57.

    Adapted from Vito Racanelli, “Should Investors Still Mind the GAAP when it Comes to Earnings,” Barron’s, February 26, 2018.

  58. 58.

    C. Fritz Foley, Jay C. Hartzell, Sheridan Titman, and Garry Twite, “Why do firms hold so much cash? A tax-based explanation,” Journal of Financial Economics, Vol. 86 (2007), pp. 579–607.

  59. 59.

    Ran Duchin, Thomas Gilbert, Jarrad Harford, and Christopher Hrdlicka, “Precautionary Savings with Risky Assets: When Cash Is Not Cash,” The Journal of Finance, Vol. 72, No. 2 (April 2017) pp. 793-852.

  60. 60.

    Edward Yardeni and Joe Abbott, Stock Market Briefing: S&P 500 Sectors & Industries, May 22, 2018.

  61. 61.

    Edward Yardeni and Joe Abbott, Stock Market Briefing: S&P 500 Sectors & Industries, May 22, 2018. Reproduced by permission of Yardeni Research.

  62. 62.

    FRED, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis, https://fred.stlouisfed.org/series/A449RE1A156NBEA

  63. 63.

    FRED, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis, https://fred.stlouisfed.org/graph/?g=cSh

  64. 64.

    Data from FRED, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis.

  65. 65.

    Ozgur Orhangazi, “The role of intangible assets in explaining the investment–profit puzzle,” Cambridge Journal of Economics (Nov 2018), available online at https://doi.org/10.1093/cje/bey046

  66. 66.

    Luke Kawa, “Warren Buffett’s [2015] Shareholder Letter, Annotated,” Bloomberg Online, February 27, 2016.

  67. 67.

    “Striking Out: The Agony of the Value Investor,” The Economist, October 27, 2018.

  68. 68.

    Feng Gu and Weimin Wang, “Intangible Assets, Information Complexity, and Analysts’ Earnings Forecasts,” Journal of Business Finance & Accounting, Vol. 32, Nos. 9 and 10, (November/December 2005), pp. 1675–1702.

  69. 69.

    Schumpeter, “As Good As It Gets,” The Economist, September 1, 2018.

  70. 70.

    Schumpeter, “As Good As It Gets,” The Economist, September 1, 2018.

  71. 71.

    Reshma Kapadia, “Are Value Stocks About to Grow?” Barron’s, April 30, 2018.

  72. 72.

    Or, as the academic literature somewhat stubbornly insists, the Book-to-Market ratio, or BE/ME – “Book Equity to Market Equity” – and similar inverted forms.

  73. 73.

    Quoted in Reshma Kapadia, “Are Value Stocks About to Grow?” Barron’s, April 30, 2018.

  74. 74.

    This failure to account for brand equity within the standard accounting framework has given rise to the emergence of a number of firms specializing in the valuation of brands, which have developed elaborate quantitative methodologies for this purpose. Interbrand (http://interbrand.com); BrandZ, of Millward Brown (www.millwardbrown.com/brandz/brandz); and Brand Finance (http://brandfinance.com) are three leading providers of brand equity valuation services.

  75. 75.

    May 2018.

  76. 76.

    Source: Standard & Poor’s (www.multpl.com/s-p-500-price-to-book

  77. 77.

    Data from NYU Stern (http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/pbvdata.html).

  78. 78.

    Data from Standard & Poor’s (www.multpl.com/s-p-500-price-to-book).

  79. 79.

    I have run a number of simple regressions on different sets of companies; some sets are chosen for diversity and others for sector similarities. The correlation between P/E and ROA is always low and often essentially zero.

  80. 80.

    Adapted from John Hagel, John Seely Brown, Tamara Samoylova, and Michael Lui, “Success or struggle: ROA as a true measure of business performance,” Deloitte Insights, October 30, 2013.

  81. 81.

    John Hagel, John Seely Brown, Tamara Samoylova, Michael Lui, “Success or struggle: ROA as a true measure of business performance,” Deloitte Insights, October 30, 2013.

  82. 82.

    John R. Graham, Mark T. Leary, and Michael Roberts, “A Century of Capital Structure: The Leveraging of Corporate America,” Journal of Financial Economics, Vol. 118 (2015), pp. 658–663.

  83. 83.

    Zvi Bodie, Alex Kane, and Alan Marcus, Investments (McGraw-Hill, various editions).

  84. 84.

    Martin Lettau and Sydney Ludvigson, “Consumption, Aggregate Wealth, and Expected Stock Returns,” The Journal of Finance, Vol. 56, No. 3 (June 2001), pp. 815–84.

  85. 85.

    For those unfamiliar with the term, a stylized fact is not an actual fact, but “a broad generalization that summarizes data, which although essentially true may have inaccuracies in the detail” (Wikipedia definition). In other words, these are statements that economists feel free to regard as facts without worrying about whether they are true or not.

  86. 86.

    The Efficient Market Hypothesis is a good example.

  87. 87.

    Ivo Welch and Amit Goyal, “A Comprehensive Look at the Empirical Performance of Equity Premium Prediction,” The Review of Financial Studies, Vol. 21, No. 4 (July 2008), pp. 1455–1508. This is a very thorough treatment, recommended for anyone who may need the statistical details. “Out-of-sample, most models not only fail to beat the unconditional benchmark (the prevailing mean) in a statistically or economically significant manner, but underperform it outright. If we focus on the most recent decades, that is, the period after 1975, we find that no model had superior performance Out-of-sample and few had acceptable performance In-sample. With 30 years of poor performance, believing in a model today would require strong priors that the model is well specified and that the underlying model has not changed.”

  88. 88.

    This is a pretty standard Wikipedia definition.

  89. 89.

    Financial Times, October 26, 27, and 29, 2009. Highly recommended. In 2013, the Journal of Economic Methodology devoted a special issue to the topic of reflexivity. Soros’ introduction for that issue is also useful: “Fallibility, Reflexivity, and the Human Uncertainty Principle,” Vol. 20, No. 4 (2013), pp. 309–329.

  90. 90.

    Soros and others connect these ideas to larger issues in philosophy and the philosophy of science and a critique of economic thinking about markets in and out of equilibrium.

  91. 91.

    George Soros, “Financial Markets,” Financial Times, October 27, 2009.

  92. 92.

    Adapted from George Soros, “Financial Markets,” Financial Times, October 27, 2009.

  93. 93.

    John Maynard Keynes, The General Theory of Employment, Interest, and Money, (1936) p. 156. Keynes and Soros both bring significant experience as successful investors to their theorizing.

  94. 94.

    P/E figures from Q4 2018.

  95. 95.

    Although of course the price looks forward – so the past trend is only indicative.

  96. 96.

    For a good intellectual biography, see Perry Mehrling, Fischer Black and the Revolutionary Idea of Finance, Wiley (2011).

  97. 97.

    Fischer Black, “The Magic in Earnings: Economic Earnings versus Accounting Earnings,” Financial Analysts Journal, November/December 1980, pp. 19–24.

  98. 98.

    The idea of capitalizing “customers” as assets is not far-fetched. In some industries, where the subscription mode of revenue is the rule – such as telecommunications – the idea of calculating a Customer Lifetime Value (CLV) has taken hold, as a useful way of understanding the enterprise value overall. CLV is calculated much like any stream of discounted cash flow: the subscription revenues are projected out as far as the average “churn” point – where on average customers discontinue their subscriptions, the customer acquisition costs and other expenses are subtracted, and the net cash flows are discounted back to a present value. A McKinsey study from 2003 calculated the CLV for several wireless carriers and arrived at values between $900 and $1800 per customer added. Adam Braff, William J. Passmore, and Michael Simpson, “Going the Distance with Telecom Customers,” The McKinsey Quarterly, 2003, No. 4.

  99. 99.

    True indexers are generally easy to identify; they openly advertise their index-tracking strategies. Closet indexers are harder to identify, and the category is not as definitive. One study in 2009 estimated that “the fraction of closet indexers increased even more significantly [than true indexers]: Funds with low Active Share (20-60%) had about 30% of all assets in 2003, compared with almost zero in the 1980s.” (K. J. Martijn Cremers and Antti Petajisto, “How Active Is Your Fund Manager? A New Measure That Predicts Performance,” The Review of Financial Studies, Vol. 22, No. 9 (September 2009), pp. 3329–3365; also Antti Petajisto, “Active Share and Mutual Fund Performance,” Financial Analysts Journal, Vol. 69, No. 4 (July/August 2013), pp. 73–93.

  100. 100.

    Jason Thomas, “Where Have All the Public Companies Gone?” The Wall Street Journal, November 17, 2017.

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    George Calhoun

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Calhoun, G. (2020). Assessments and Qualifications. In: Price and Value. Apress, Berkeley, CA. https://doi.org/10.1007/978-1-4842-5552-0_6

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