My Journey in Investing: Valuations
After I finished this algorithm, I became instantly dissatisfied with the approach. I felt as if it was too fluid and subjective. Instead, the idea of mathematically creating my own valuation of a company was enticing. If I was able to model the Market Cap of a company with its financials that are released on the SEC website, I could use that to understand whether or not a stock is under or overvalued and purchase accordingly. I tried to research various ways through which valuations were made such as a Discounted Cash Flow (DCF). Of course, this required creating projections of cash flow, and I did not have enough information or expertise to make such estimates. As I read more and more, I realized that the information needed for most evaluation methods required plugging in future metrics that I wasn’t experienced enough to reasonably predict.
While this was disappointing, it did lead me to another strategy. Since it was difficult to complete an absolute valuation of the stock, I decided to employ a relative (or comparative) valuation model. This was much easier and would involve using only a couple of specific metrics. After reading this incredibly useful Investopedia article I created the sheet below.
This uses the metrics provided by GoogleFinance to evaluate the comparative value of my positions. The first step was creating a list of competitors to the companies I was invested in. I had to be sure that their business models and products were categorically similar. For LuLu Lemon, I added other luxury activewear brands; for Boeing, I added other airplane manufacturers; for Delta, I added other airlines, and for Netflix, I added other online media-services providers.
I used GoogleFinance to list each company’s Market Cap, current price, and yearly highs and lows for some context. The important information, however, was found in the ratios next to that. I primarily used the Price-To-Earnings and Earning Per Share ratios to compare the businesses. EPS describes the ratio between a company’s profit and its shares outstanding and is meant to represent how profitable one’s investments in a company are. P/E is the ratio between the price of the shares and the EPS. P/E allows us to compare the relative valuation of similar companies and to see if one is over or undervalued.
According to Investopedia:
A company with a high P/E ratio is trading at a higher price per dollar of earnings than its peers and is considered overvalued. Likewise, a company with a low P/E ratio is trading at a lower price per dollar of EPS and is considered undervalued.
This allows me to make smarter purchases by gauging whether or not the stock is expected to increase or decrease by working towards this comparative value in the future. As demonstrated by the Dot-com Bubble, however, if the entire industry is overvalued then purchasing a relatively undervalued stock due to its P/E ratio will not end up well.
Returning to the sheet, you can see how this ratio points to the flaws I made in investing. Nearly all my positions have the highest P/E ratios of their competitors indicating that they may be overvalued. This is troubling, however, it is important to remember that this is only one value and thus gives a partial picture. Since companies like Google and Amazon are already so massive, it may even be expected for them to have such P/E ratios. In order to get a better understanding, I need to integrate a couple more metrics in the sheet. These being- return on equity and operating margin.
Ultimately, however, for the first five months (September 2019 to January 202), my shares performed quite well. To be honest, I could have randomly chosen my positions and have found success due to how bullish the market was. This soon changed, as I’ll detail in my next couple posts that will cover the impact of Covid-19 on the market and my portfolio.