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Beyond the Numbers

Beyond the Numbers

Trusted advice to help you think big and plan bigger.

The Difference Between Price and Value

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Research Analyst
Research, Cincinnati

“Darkness was cheap, and Scrooge liked it.” –  Charles Dickens, A Christmas Carol

As a consumer, one of the big mistakes I’m prone to make is buying the “cheap” item that, in the long run, ends up costing more than the “expensive” option I put back on the shelf.  

Here’s an example. About ten years ago, my wife and I were shopping for a couch to put in our first home. We wanted a brown leather couch and went to a local furniture store to find one we liked.

As we looked at the real leather couches, I turned over the price tags and was stunned at how much the store was asking. My attention quickly turned to the faux leather couches, which were a fraction of the price of the real leather options.

“Who would know the difference,” I rationalized to my wife, “and just think about all the money we’re saving.”

Fast forward five years and the fake leather couch was falling apart – quite literally – and I was back in the market for another couch.

What I failed to recognize then is the difference between price and value. Had I made the investment in one quality couch upfront, I would have saved myself from ultimately paying for two couches in a five-year period. Or as my wife now reminds me, “buy cheap, buy twice.”

Price and value

As investors, we can also be susceptible to this faulty logic. We might, for instance, view stocks with low price/earnings ratios as “cheap” and those with high price/earnings ratios as “expensive.” Looking at absolute price/earnings (or similar valuation metrics) in isolation, however, just doesn’t provide enough context to make a good value judgment.  

In January 2001, for instance, Eastman Kodak traded with a trailing price/earnings ratio around eight times. Concurrently, Lowe’s traded with a trailing price/earnings ratio around 25 times.

At first glance, an investor in early 2001 might have reasonably concluded that the beaten-up blue chip, Kodak, looked cheap and that the growing home retailer, Lowe’s, was expensive.

By January 2006, the opposite proved true when we compare the two companies’ future earnings compared to the original prices we paid for the shares.

Assumes prices and trailing-twelve-month earnings on January 31, 2001-2016. Data provided by FactSet.

 

As the above table illustrates, while you initially paid nearly $25 for each $1 of Lowe’s previous year’s earnings and just $8.10 for every $1 of Kodak’s, you were buying a growing earnings stream in the former and a shrinking earnings stream in the latter. Within a few years, Kodak was operating at a loss and your cheap-looking investment got a lot more expensive. Conversely, Lowe’s subsequent earnings growth more than justified its initial price tag. 

 

1/31/2001

1/31/2006

% Change

Eastman Kodak

100

68.6

(31.4)

Lowe’s

100

240.9

140.9

S&P 500

100

101.9

1.9

Total return data provided by FactSet. Indexed to 100 on January 31, 2001.

Yes, this is a cherry-picked example selected with the benefit of hindsight. And no, this is not an endorsement of blindly buying stocks with 25 price/earnings ratios.

What the comparison does show, however, is that our focus should be on the multiple relative to the underlying strength of the business.

Could we have known?

Looking at the years leading up to your investment decision in January 2001, we can see two companies on very different trajectories.

Between year-end 1996 and year-end 2000, Lowe’s added hundreds of new stores while improving profitability. Further, Lowe’s increased its small dividend by approximately 10% annualized, indicating some confidence at the management and board level.

Lowe’s

1/1997

1/1998

1/1999

1/2000

1/2001

Sales per Share ($)

6.23

7.27

8.65

10.36

12.21

Cash Flow per Share ($)

0.39

0.48

0.49

0.76

0.73

Dividend per Share ($)

0.0275

0.0288

0.030

0.035

0.04

Data provided by FactSet

By comparison, Kodak was still generating plenty of cash flow leading up to January 2001, but cash flow per share was erratic, as was sales per share. These factors, plus the fact that Kodak’s dividend was held flat for four years suggests the board lacked long-term confidence.

Kodak

12/1996

12/1997

12/1998

12/1999

12/2000

Sales per Share ($)

47.33

43.80

40.90

43.82

45.64

Cash Flow per Share ($)

7.36

6.27

4.52

6.01

3.20

Dividend per Share ($)

1.60

1.76

1.76

1.76

1.76

Data provided by FactSet

In other words, there were good reasons for investors to be both optimistic about Lowe’s and pessimistic about Eastman Kodak in January 2001. Though Lowe’s traded at a premium multiple to the S&P on January 31, 2001, an investor who balked at buying Lowe’s for being “expensive” and instead bought Kodak because it was “cheap,” ended up being much worse off.

So just buy great companies?

Great companies don’t always make great investments. Valuation matters.  Indeed, had you instead invested in Wal-Mart on January 31, 2001, when it was trading with a price/earnings ratio around 41 times, you would have had a disappointing long-term result. Through March 29, 2017, Wal-Mart’s total return was 67.1% versus the S&P 500 at 138.3%. 

To see why Wal-Mart performed as it did, however, let’s break apart its total return over the past sixteen years into “fundamental” (dividend yield and earnings growth) and “speculative” (change in price/earnings) returns.

Data provided by FactSet. Assumes investment on January 31, 2001, through March 23, 2017. Except for dividend yield, all figures are compounded annual growth rates.

 

From a fundamental perspective, Wal-Mart as a business performed well – just not as well as the market in January 2001 expected it would over the subsequent sixteen years. With the benefit of hindsight, you certainly overpaid for Wal-Mart at 41 times earnings, but your valuation mistake was offset by improving fundamentals. 

Being right on the company’s quality and wrong on its valuation usually results in disappointing, but ultimately survivable, results.

The same can’t be said with low-quality firms. Without supporting fundamental growth in the business, you’re relying entirely on your valuation thesis. If you’re wrong here, you run a higher risk of permanent loss of capital. 

Avoiding value and quality traps

This is why, at Johnson, we start with a quality evaluation. Among other things, we evaluate the strength of the company’s management team, long-term competitive position, balance sheet health, and earnings quality. Ideally, this will help us avoid Kodak-like value traps.

Once we believe a company to be of high quality, we compare our expectations to what we think the market is expecting of the business. If we conclude that the market’s expectations are too high relative to our outlook, there’s a good chance that it’s not the right time to invest from a valuation perspective. This aim of this valuation discipline is to avoid overpaying for quality firms.

Bottom line

Just as consumers should evaluate a product’s price in relation to its quality before determining value, investors should do the same. Absolute price multiples don’t often tell you the whole story about a stock. Only by researching the underlying business are we able to make a prudent judgment on its investment value relative to its current price.

Stay patient, stay focused.

Todd

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(Cover image credit: Ronald Searle)

Disclaimer

Todd Wenning is a Research Analyst with Johnson Investment Counsel (“Johnson”).  Johnson clients own shares of Wal-Mart and Lowe’s.

This article is not meant to be a recommendation toward the sale or purchase of any of the securities mentioned in the article. The contents of this article express the opinions and views of the author and do not necessarily reflect the opinions or views of Johnson or its employees.

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