Alternative Ways Retail Investors Can Value Stocks

Wall Streeters may now have cause to be more confident about stock valuations than at any time in the last two years. That's a result of continually improving economic data, a consensus forecast by analysts for 30% higher earnings for the Standard & Poor's 500-stock index in 2010, expectations of lower unemployment, and the prospect of continued low inflation and interest rates. On Mar. 23, the S&P 500 index closed above 1,170 for the first time in 18 months, putting the broad market at 15 times the consensus earnings forecast of $78 a share for 2010.

Alec Young, equity strategist at Standard & Poor's Equity Research, believes the 15 times multiple constitutes a valuation ceiling until the market sees either dramatically improved monthly jobs numbers or more likely, first-quarter earnings results that meet or surpass market expectations. Young sees price-to-earnings valuations as a fairly efficient measure of stocks' true worth and says it's very rare that valuations get totally distorted, as they did during the tech bubble in the late 1990s.

Still, there's enough interest in beating the market to fuel the search for better valuation methodologies. Bloomberg BusinessWeek finds two fairly new approaches available to retail investors worthy of note.

The first tool is based on the concept of economic value added, or EVA, which Bennett Stewart created nearly 20 years ago as a way for companies to include the cost of capital in their profit forecasts when making business decisions.Stern Stewart & Co., a management consulting firm that Stewart co-founded in 1982, has long argued that EVA—calculated as the difference between net operating profit after taxes and the opportunity cost—is a better measure of shareholder value than earnings per share, which can be pumped up in the near term by investing too much capital for too low a return, or by cutting research and development spending, the basis for long-term growth.

Tool For Fidelity investors: PRVit

A stock rating system called PRVit—which stands for performance, risk, valuation investment technology and is pronounced "prove it"—uses the EVA methodology and has been available to institutional investors since 2005. In November 2009, EVA Dimensions, a Stern Stewart spin-off, licensed a retail version of PRVit to Fidelity Research Management, which added it to the stable of research tools that Fidelity makes available online to its customers. EVA Dimensions' licensing agreement with Fidelity isn't exclusive, but it has yet to arrange for distribution through other retail channels, says Stewart, the company's chief executive.

PRVit is a ratio calculated by subtracting a risk measure from a company's EVA and then dividing it by the stocks' current market valuation. The ratio is converted into a percentile index on a scale of 0 to 100 where the higher the number, the more desirable the stock is as an investment; the lower the number, the better the case for shorting the stock. Fidelity customers can enter the ticker of any stock in the Russell 3000 index, as well any of the 200 largest ADRs that trade on U.S. exchanges, and see the stock's PRVit score.

PRVit ratings are the same for retail and institutional users, but the retail version of the research is depicted more as a visual snapshot while institutional users get a far more detailed analytical report. Fidelity doesn't allow users to save or share reports the way institutional investors can. PRVit's real strength, says Stewart, is in showing the value of stocks within a given industry, rather than in timing trades across different sectors.

Within the first month of being launched, EVA Dimensions' research was among the most viewed of the 21 research options on Fidelity's Web site, which a Fidelity spokesman attributes to the quality of the company's research.

OCE Interactive's Market Topographer

Fidelity customers also have access to three "expert strategies" that highlight categories of stocks offering good value to investors. Value-at-a-Reasonable Price, or VARP, gives you the stocks with the highest PRVit rating on the day you run the program. Laggards with Legs finds small and midcap companies with PRVit scores over the 80th percentile that have been beaten down and can be bought at bargain prices. Franchise Players identifies solid companies trading at less than their intrinsic value, as judged by their PRVit scores (which must be over the 80th percentile in their sector to qualify), and which typically have a real franchise value not fully recognized by the market.

Market Topographer, a web-based platform that launched in January, takes an EVA-like approach by factoring capital costs, unrealized earnings capacity tied to fixed investment, stock price volatility, and nine other characteristics into stock valuations. Developed by OCE Interactive, a New York firm formed by former investment bankers and Wall Street executives, the platform's interactive tools allow you to assess the reasonableness of the future expectations priced into a stock and the impact of market conditions on that price. It also lets you directly compare the risk profile and valuation of a stock with other stocks—currently, historically, or across time. The goal is to help people "reduce subjectivity in their buying decision, based mostly on objective facts," says Jonathan Greenberg, chief executive of OCE Interactive.

The company plans to release six modules eventually but currently offers two for which patents are pending. The first, called Breakdown, lets you compare the risk and fundamental profiles of any two publicly traded U.S. stocks and learn what's driving their relative valuations, both currently and across time. Breakdown lets you judge whether risk is being properly priced for a given stock vs. others you could invest in. For any two companies you pick, the program identifies the relative exposure to each of 12 risk-assessment factors, qualifying each as a relative valuation pro or con and ranking them according to how much the market rewards or penalizes each at any point in time. As a result, you may realize that a company trading at eight times earnings isn't necessarily cheaper than one with a 15 times multiple.

The second module, Based on Experience, lets you evaluate the expectations currently priced into a stock, based on comparisons with the actual achievements of a broad array of relevant companies over time. This helps you decide whether a company's stock price has gotten ahead of itself. For example, to gauge Starbucks' (SBUX) growth potential, you would look at its annual earnings base, which is roughly $800 million. The program finds all the companies with a similar earnings base—adjusted for inflation—going back 20 years, then calculates the rate at which each company was able to increase its earnings base over the next 10 years and how their dividend policies evolved over those periods. Based on Experience also shows how stocks with risk and fundamentals profile similar to a given stock today would have been priced historically. If the current price of a stock is below the average of these historically implied prices, it might suggest that this is a good time to buy it.

apply discipline to valuation process

The analysis that Market Topographer provides about how each risk-assessment factor contributes, positively or negatively, to a stock's valuation generally accords with common sense. For instance, there's logic in the market's willingness to pay more for a company with little or no debt than for one with a lot of debt. Greenberg concedes the need, when doing credit research on companies, to distinguish between different uses of debt and the various maturities and coupon rates companies are paying. Statistically, he's found that the most significant common denominator among companies is the simple measure of net debt as a percentage of total capitalization.

"Asset managers are looking for more objective ways to bring discipline to their valuation process," says Greenberg. "They're already looking carefully at companies' particular situations, expansion plans, and credit quality."

He adds that Market Topographer is only providing benchmark prices to help users understand the big-picture rationality of stock prices and "not giving them recommendations or providing price targets the way a third-party research firm does in telling you where a stock should trade."

EVA Dimensions is working on the next-generation version of PRVit, aiming to make it possible to calculate a consensus estimate of EVA among market analysts. Stewart expects this to be available in roughly a year. "I would like to ultimately change the dialogue on Wall Street so that instead of talking about consensus [earnings per share], they're talking about consensus EVA," he says.

Skeptics argue that methodology isn't the issue when it comes to identifying mispriced stocks. "You've got to find some information that the market isn't incorporating into its price or its expected return," says Espen Eckbo, a finance professor at the Tuck School of Business at Dartmouth College.

As seductive as new tools may seem, it's worth keeping in mind the weight of historical data that concludes that active managers hardly ever outperform the market—certainly not consistently over time.

"Active management can work, but it takes a lot of time and it's hard to do," says Jack Rader, executive director of the Financial Management Association International in Tampa, Fla. Since he believes people should invest only in industries that they fully understand, "there will be times when everything in the industries I understand is fairly priced or overpriced. I've got to be willing to sit on the sidelines when that's happening and I've got to be willing to do an immense amount of work."

Consequently, Rader says, he's an advocate of index investing for practical purposes. "Most of us are not willing to do all the hard work."

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