Creating Valuation Scores from Key Metrics

Summary

  1. Are you a market timer?
  2. I like to buy low and hold for the long term. When I sell, I prefer to sell high.
  3. Does that make me a market timer or just a sensible investor?
  4. Introducing “valuation scores” to identify potentially overvalued and undervalued stocks.

I am an income investor with a focus on “Immediate income investments” and a few “Dividend Growth Investments”. Somewhere along the way, I discovered that it was important to develop and maintain my own database of stocks that I could follow, research and ultimately invest in when the time was advantageous. This became a huge endeavor, but during the journey, I learned that investors must base their decisions on many different historical financial metrics, including:

  1. Earnings
  2. Payout ratios
  3. Debt ratios
  4. Dividend metrics.

I consider these 4 areas of analysis to be the most important, but there are many other things to consider, such as credit ratings, total return figures, stock charts and more.   All of these things help me to uncover strong companies that can provide a reliable and sustainable dividend. However, as time progressed and stock prices fluctuated between higher highs and lower lows, I realized that I was missing a key metric – valuation. I discovered that I could find great stocks that met my personal investment goals; however, I was often not comfortable with the prices because the yields were lower than I wanted. By looking at a stock chart or the 52-week low and highs, I could see that prices had been lower over the course of the year. And with all of the information available to me, I had no way of knowing what a fair or realistic price was for a particular stock.

Then I read Chuck Carnevale’s Seeking Alpha article entitled “Why Value Investing Works for All Stock Categories”. In the article, Chuck talked about valuation and how important valuation metrics are when investing. One phrase stuck with me: “Buy above average stocks at below average prices”. I have also read the Part Time Investor (PTI) who has his own metric for valuation based on comparing historic yield to current yield. These authors and others made me realize the importance of providing and using valuation metrics to help me compare current financial metrics to historical averages.

Valuation Metrics

It would be great if we could use one financial metric to determine if a stock was under or over-valued, but after trial and error, it became clear that there are reasons why one metric is not always reliable. In the end I have targeted yields and price to earnings. To be specific, we are now using the following valuation metrics:

  1. Current yield compared to 10-year median yield.
  2. Current P/E compared to 10-year median P/E.
  3. Current P/NG-E compared to 5-year median P/NG-E. (Price to Non-GAAP Earnings)
  4. Current P/EBITDA compared to 10-year median P/EBITDA (Earnings Before Interest, Taxes, Depreciation, Amortization)

Price to Earnings” is among the most basic measuring tools used by investors. Investopedia states “P/E ratios are used by investors and analysts to determine the relative value of a company’s shares in an apples-to-apples comparison. It can also be used to compare a company against its own historical record or to compare aggregate markets against one another or over time”. We also use Price to Non-GAAP earnings for stocks that report Non-GAAP earnings, such as MLP, REITs, etc.

Yield is probably the most important metric used by income investors.   Yield refers to the earnings generated and realized on an investment over a particular period of time, and is computed based from income compared to current price or price paid to obtain the income.

Price to EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). EBITDA is one indicator of a company’s financial performance and is used as a proxy for the earning potential of a business. As with Yield and P/E, we relate EBITDA to Price so that all valuation metrics are tied to stock price.

“I Prefer Income” now uses valuation scores

We have now added Valuation to the REIT, MLP/Midstream and Dividend Diamonds 25+ programs. The column is located to the right of Debt and all programs display the Yield valuation score. If you then click on the yield score, a popup table with 2 valuation scores will be displayed (see below). The 2nd score will depend on the type of stocks are being followed. Dividend Diamonds 25+ will display P/E scores. REITs will display P/NG-E scores and MLP/Midstream displays P/EBITDA scores.

The key is to remember that all negative scores indicate that the stock is potentially undervalued, and all positive scores indicate that the stock is potentially overvalued based on the relationship between current and historical metrics.

Creating Valuation Scores from Key Metrics

Market Timing or Sensible Investing

The addition of valuation metrics is another tool for investors to use when analyzing a stock to buy or sell. By itself, it may not mean much, but when used together with other important metrics, it can help define the condition of a company and its stock. I call that sensible investing. I hope you enjoyed the article and found it to be of value.   If you are not a member, please consider joining. All memberships are FREE. Just go to our website and click on Register

Besides this article, I have also posted a new video providing information on Immediate Income Investing and in selecting a few good “high yield” REIT stocks to consider investing in. During the video, I also provide more information on the Valuation Metrics.

To visit the I Prefer Income website: Click Here

**Please remember that all investments have risk and there is no guaranty that they will provide the results you want. However, by doing quality research your chances for success are greatly improved.

Thanks for reading,

Rich Hill

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