Keep It Simple: 11 Rules for Equity Valuations
“We need to do something,” James J. Valentine, CFA, told the audience at the CFA Institute Conference: Equity Research and Valuation 2017 in New York City. The asset management industry is, in Valentine’s words, “A house on fire,” with investors moving $1 trillion from active to passive US equity funds over the last decade.
Valentine doesn’t anticipate that trend will reverse anytime soon, so equity analysts need to come up with solutions.
For Valentine, the founder of AnalystSolutions, that means following 11 rules of thumb when determining equity valuations and setting price targets. He derived these guidelines from the lessons he accrued during his 14 years as an equity research analyst and in his efforts to educate and train analysts and associates.
The underlying philosophy behind his guidelines can be summed up in one phrase: “Keep it simple.”
1. Avoid Complexity
The first and most critical of Valentine’s rules is inspired by three components:
- Occam’s Razor: When choosing among competing hypotheses, go with the least complicated.
- Ray Solomonoff’s theory of inductive inference: “Shorter computable theories have more weight when calculating the probability of the next observation.”
- A quote often attributed to Albert Einstein: “Everything should be made as simple as possible, but not simpler.”
“We don’t want to be doing rocket science here,” Valentine explained. “Complexity is not our friend. . . . The more complex, the more likely something’s going to go wrong.”
To illustrate his point, he highlighted an analysis of discounted cash flow (DCF) models. Out of a sample of over 120 reports from US brokers in 2012 and 2013, researchers found that for each DCF, analysts made a median of three theory- or calculation-related errors and four decisions based on faulty economic judgments.
Those errors came at a cost. After correcting for the mistakes and recalculating, the researchers found the mean valuations and target prices were off by between -2% and 14%.
2. Derive an Accurate Forecast before Starting Valuation
Accurate forecasts are products of the subtle application of skills and tools, according to Valentine, and it is critical to know the difference between the two.
Tools like Excel and valuation models, for example, whether derived from software or formulas, are useful, even essential, but they can only offer so much. And they have drawbacks, producing mountains of sometimes unhelpful and distracting data while burning up valuable time and mental capacity. They create what Valentine refers to as “Stay-Up-till-Midnight Syndrome,” where analysts focus on mastering tools, not skills.
Skills are the filters that assess this data and decipher the patterns that lead to good forecasts and accurate valuations.
What factors drove the stock in the past? What is going to drive the stock in the future? Skills are required to answer those questions. Detecting deception and understanding market sentiment are also vital for successful equity analysis.
“I would contend that these are skills,” Valentine said. “The analogy I’ll use is if we’re trying to be a sculptor, we probably wouldn’t spend a tremendous amount of time trying to select the chisel.”
3. Focus on One to Four Critical Factors per Stock
This rule comes down to answering two questions, according to Valentine: Which factors are going to move my stocks and where can I get unique insights on these factors?
“The best analysts are just focused on one or two factors per stock,” he said. “I find too often analysts get distracted.”
4. Don’t Seek Out-of-Consensus Ideas from Company Management
“The best analysts are finding unique sources of information,” Valentine said. Company management does not qualify as unique.
Good analysts will find proprietary sources for their forecasts and valuations. During his time covering stocks, Valentine sought out industry consultants and managers of privately held companies for their perspectives.
“If analysts rely only on public information, the best they can come up with is consensus,” he said. “The less I spoke to my companies, the more successful I got.”
5. Start with the Consensus Valuation Method
A good jumping-off point for valuation is the consensus method, whether it’s DCF, P/E, EBITDA, etc. Often the consensus method is the right one, so only use an alternative approach if it adds value and insight and isn’t a time sinkhole.
6. Stress Test with Scenarios
“Our job is to think about where we can be wrong,” Valentine said. “We probably wouldn’t need valuation if our forecasts were accurate into perpetuity.”
So calculate an upside and a downside along with your base case as you analyze a stock and play out those scenarios. It doesn’t have to be that complicated.
7. Identify Uniqueness of Forecast and Valuation
What makes your analysis different? Where does it diverge from the consensus? “Dissect how you differ,” Valentine said. And don’t change your price target unless there is ample reason, whether a revised forecast, a revised multiple, or a new valuation method.
Another critical point: If you’re going to change your price target, don’t do it incrementally.
“I find that there’s really one good reason to change your price target: If you’ve got a new price target,” he said. “We want to avoid these incremental steps and just be bold.”
8. Know “What’s in the Stock”
Talk to all market participants to understand the consensus on a stock. What’s the outlook among buy-side analysts? How about sell-side traders and analysts? What’s the company saying? How do all these data points fit into your own calculations about the stock and the narrative you’re constructing around it?
Valentine: Determining “what’s already in the stock?” is like a CSI investigation. Historical relative PEs work well for clues #EquityNY @analystsolution
— Julie Hammond, CFA (@JulieSHammond) November 14, 2017
It is important to understand what the expectations and the major concerns of the market participants are and where those fit into the larger market outlook.
9. Minimize Mind Traps
Analysts need to be mindful of and correct for their own internal flaws, keeping their emotions in check and steering clear of the overconfidence mind trap, the heuristics mind trap, confirmation bias, and the like.
“Make sure we know there’s always a different view on a particular stock,” Valentine said.
He also recommends keeping a good handle on stress, referring to the “Yerkes-Dodson law,” which holds that too high or too low a level of stress negatively influences performance.
“A little anxiety is good,” he said. “None or lots is bad.”
10. Use a Dynamic and Comprehensive Comp Table
“The better comp tables are more dynamic,” Valentine said. Make sure yours update stock prices automatically and flag when your forecasts run counter to consensus. They should also keep track of how your recommendations have performed compared to the universe of stocks and the market as a whole.
Valentine also recommends reviewing your valuations at least once a week, if not every day.
11. Cover Fewer Stocks and Sectors
In conversations with analysts, Valentine said he’s often taken aback by the sheer number of stocks analysts are responsible for.
“Way too many analysts tell me they have 100 or 200 stocks they’re trying to cover,” he said. “How many stocks can you cover and still generate alpha?”
Certain sectors — airlines, for example — may move more or less in tandem, depending on, say, fuel costs or some other factor that influences the industry as a whole. Other sectors — biotech, for example — have immensely divergent outcomes based on difficult-to-quantify inputs. Stock pickers can’t analyze everything. So it is critical not to spread yourself too thin.
There is a “sea of mediocrity” out there, Valentine said, so good stock pickers need to determine where they add value and direct their focus there.
That’s how they can start to put out the house fire that is consuming the sector.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image courtesy of Paul McCaffrey
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19 thoughts on “Keep It Simple: 11 Rules for Equity Valuations”
Excellent tips. Thank you.
Amazing tips. Simple, comprehensive and effective.
My opinion: this is not incredibly impressive and contains somewhat conflicting statements. Understanding that consensus of analysts would generally encompass company management consensus in it means that management commentary is included however you are now relying on the analysts assessment of this factor… would be one example of why I do find favour in the steps.
However, I agree whole heartedly that “keep it simple” is the key to ensuring that equity analysts remain an integral value adder to the process of stock selection within portfolios.
Do not find favour*
I disagree with your opinion Chiara ; It isn’t logical, I think! Consensus are wrong sometimes too. A popular example is some experience we had during the US subprime mortgage frenzy more than a decade ago.
I agree with Ahmed reason being sometimes the statistics i.e the numbers lie you can be dragging yourself with the consensus yet there’s an hidden variable no one has noticed or no one is talking about which influences the stoke
superb. more thought. less numbers.
The first step is to figure out what is priced into the stock and use many methods to establish this. It does not require forecasting skills, as in predicting the future. We should all accept that we are pretty much useless at this. Just back out what is in the price. Until you have that position plotted on your valuation map (swamp, fog, desert, peak…you get the idea) you will not have any idea where to go next.
Trying to assess the future earnings is like throwing a dice and hoping you will get a 6 every time. Prefer looking at how well management has allocated capital in the past by just looking ROE’s, ROCE’s, Sales Growth within the industry because at some point a great company will always surprise on the earnings and then stock prices adjust fast and the more “bullish” analyst then end up assigning a more than fair value.
Advice not helpful. Stocks are not simple. Tell the me the “one or two” factors that drive Amazon’s price! A good piece of advice I read somewhere. Ask yourself –Is my belief
1) seem true
2) what I would like to be true
Often our beliefs are in categories 1 and 2.
Great advice! Perhaps No. 12 might be to gain a thorough understanding of corporate financial statements to identify analytical issues not readily apparent…
According to US NCOA (National Council of Aging), with seniors living longer and more active lives, and with more than 77 million baby boomers turning 65 at a rate of 10,000 per day, the United States is experiencing historic growth in the 65-plus demographic. This growth is pressing communities to think differently and more broadly about a whole host of issues: housing, transportation, social services, cultural
offerings, and health and wellness programs, to name just a few.
By 2030, 1 of every 5 people in the United States — or 20 percent of the nation’s population — will be age 65 or older.
According to Census.gov, statistics show the facts and the importance of such factor, population aging, in investment industry and steady transition from enterprise to defensive investor as a result of risk profile changing which maybe underestimated.
Enterprise investors are information motivated traders which their analysis are conditional and expecting returns more than normal which may not be suitable for people in upper stages of life, as their problems may get more severe. The financial system is there to solve people financial problems.
Enterprise investment managers the way of thinking is something like, If it happens, if it’s going to work, then I will have a tour of Japan in mind for you.
Education levels are increasing among people ages 65 and older in 1965, only 5 percent had completed a bachelor’s degree or more. By 2018, this share had risen to 29 percent. I am not telling education could guarantee the success in investments, Sir. Isaac Newton was not. But it could be considered as a pessimistic factor by those active investment managers and funds which are the followers of Wall Street think tank.
Formulas work. I love formulas.
“I’m in love with my car” by legendary Queen.
Now the question is, does equity valuations and setting price targets based on whatever pessimistic thinking, rules or formulas could change the trend or even boost pivoting towards active investment without paying attention to the other side of equation?
Keep It Simple: 11 Rules for Equity Valuations by Paul McCaffrey is a good squeeze without the forbidden fruit.
Not only the US community but other ones with increasing rate of aging are rationally more Graham centric. It is not about valuation methods and formulas which worked in past or patterns in huge quantities of data found by analysts in the h7ope that it works out.
I am investing stocks in Vietnam. I read some books in MBA and CFA program. I see that the hardest task is to forecast the future growth. this forcasting require the analysis of competition, a big topic which MBA program discuss deeply.
I see that CFA program focus too much an valuation process which is dependent on forecasting.
I have read many books on strategy to find how companies compete and so, realize which companies would grow.
investment in the stocks is about all aspects of doing business because all these aspect affect the growth and existance of the companies.
companese exist and grow because they possess some competitive advantage or perform innovation , which also to find new competitive advantage. this topic should be included in CFA program.
if we focus on competition, we can be far from valuation complex which normally attract us. remember the data in financial report show a competitive positioning and an industry demand at a time financial report is made. but both competitive positioning and industry demand change, the first more stable ,the second more dynamic.
it is the second, industry demand, which affect stock prices most because it is dynamic .
but it is the first, the competitive positioning which format our investment dicision.
the takeaway is we analyse competitive positioning first, find out the companies with good competitive positioning and after this job, we analyse industry demand. we can react to changes in industry demand rather quickly to buy in and sell our stocks.
If you can take care of point number 2 – ‘Derive an Accurate Forecast before Starting Valuation’, you don’t have to worry much about other pointers.
But this is the most difficult task also.
Simple but excellent advice!
“keep it simple” is not easy to have. we need to forcast before to valuate. to forcast is a complex anaysis of competition and requires experience to so. valuation need to be quick and good at number.
forcasting is process of realizing future in long term. a strategic point of view is required. we need assumption about customer demand and competition in the future , which could be different from the past, to make a future earning of the firm. this required experience
“Goodwill” may not be as good as the balance sheet says it is.
The article is superb.. what works on wall street is only simplicity..