Drivers of Stock Valuation - Key Takeaways

John Lafferty, managing director at Corporate Executive Board  led the March 15 webinar.  Many of you may know John as the founder of JM Lafferty & Associates. Over the years his financial and valuation expertise has helped many companies drive and deliver corporate and divisional business performance.  

John Lafferty, managing director at Corporate Executive Board  led the March 15 webinar.  Many of you may know John as the founder of JM Lafferty & Associates. Over the years his financial and valuation expertise has helped many companies drive and deliver corporate and divisional business performance. 

 I’ve done my best to capture John’s unmatched insights. I encourage you to tune in to John’s archive you are definitely learning from the master here! http://www.media-server.com/m/em/7e7ozona/r/1

 Let’s start with the Misconceptions About Valuation

 One is that P/E ratios alone do not help in understating valuation. They are commonly viewed as related to expected earnings growth.  In fact, the PE to Growth Ratio is a frequently used valuation method with lower ratios viewed as a favorable valuation indicator.  However, the empirical evidence is that there is no relationship between the two.

.Many believe that three other factors drive a company’s  value.  I will call it the “if only we had” list:

· More trading volume derived from proactive marketing of the stock

· Increased analyst coverage

· Better interest from institutional investors.

 Using the S&P 500 stocks John’s analysis illustrated that there is no direct correlation between higher valuation (P/E) and any of the three “if only” scenarios

 These results are significant to IR.

 Analysts  have to deal with stock prices based on multiple decade forecasts that are revised with ever quarterly report and news release. As we all know, the market is a  task master and not an easy grader of performance. 

 Valuation Basics

 There are three variables to think about regarding valuation: amount of money invested, or growth of the enterprise,  the return on those investments, and finally the discount rate or cost of capital that brings expected flows back to a present value.

 John’s empirical analysis supports the concept that wealth is created is when a company earns a premium return above cost of capital  and declines when companies earn less than the cost of capital.

 Using a Net Return on Equity vs. Price/Equity Ratio chart and current market data John showed how net return on capital and the price/book value are related, providing empirical support to the theory.

 While company managements agree with these theoretical underpinnings, he frequently gets questions as to why analysts rely on simple rules like PE to growth and why portfolio managers are not interested.  Managements perceive institutional investors as short term oriented and ‘never’    get questions about cost of capital or ROI.  CFO and IROs often ask ‘why should I care about this stuff if the market doesn’t?’

 The answer lies in time horizons: analysts are focused on relative earnings and relative value – their inclination and compensation are based on understanding inflection point  As they are paid to have the most recent info. In the short term, changes in earnings dominate changes in cash flow.  

Thus multiple decade forecasts are influenced by each quarter’s results as earnings models get redone.  Thus these short term changes do have an important impact on multiple decade forecasts.

 Remember, the market has very long time horizon – and we are all in this for the long run!