How to evaluate stocks today

By Morningstar |  30-05-20 | 

Professor Aswath Damodaran presented on The Value of Everything in an Unstable Environment at the  CFA Institute Annual Conference. Below are some takeaways.

Don’t abandon valuation fundamentals during the COVID-19 crisis.

With so much uncertainty around companies’ future earnings growth, cash flows, and even their ultimate survival, it’s tempting to give up on traditional equity valuation methods. Pre-crisis historical financial data seem useless and there’s a wide range of predictions about the economy and individual companies for 2020 and beyond. To value individual companies, stick with traditional valuation tools with adjustments for the pandemic.

Everything I have learned about valuation has been in the context of a crisis. It is precisely times like these that valuation fundamentals matter the most. You need to go back to the first principles of valuation.

Not all sectors were hit similarly.

By dissecting more than 36,000 public companies, in various sectors across the world, between February 14 and March 20, and looking at P/E ratios and dividend yield, unlike other crises, this was not a full-scale panic where all stocks were punished indiscriminately. There was actually a rationality of how markets knocked down stocks.

The best-performing industries ranged from those providing possible solutions to the COVID-19 pandemic, such as health care, pharmaceuticals, and biotech, with the possibility of generating profits, to low capital intensity businesses and those supplying everyday goods like toilet paper and food.

The worst performing sector? Financial services, which fell 26% from February 14 to May 1, 2020. Banks either live in reflected glory or reflected pain. When oil companies default or when travel companies and airlines refuse to pay on their loans, guess who’s holding the loans?

The second-worst performing sector was energy, with a global demand shock combined with an OPEC supply glut causing Brent and West Texas Intermediate crude prices to decline 53.6% and 62.2%, respectively.

The firms and sectors in the eye of the COVID-19 storm were those linked to travel, consumer discretionary, and people-intensive businesses, those with high fixed costs, and young start-ups — and across the board, those with high net debt loads.

The common denominator for many of the worst affected companies was high up-front investment usually funded with debt. The cautionary tale coming out of this crisis is companies should be much more careful about pushing the financial leverage button to obtain growth. This is the dark side of debt.

Growth and momentum outperformed value. Traditional “safe” stocks with low P/E ratios, low momentum, and high dividend yields were actually among the least safe places to hide.

Make adjustments to DCF valuation models by asking a series of questions:

  • How will earnings growth be affected in 2020 and how much of this effect will linger for the long term? The current year will be a bad one, but it’s important to figure out how much earnings will recover by 2025 or 2029.
  • How will fears about the future affect what percentage of earnings is returned to shareholders through dividends and buybacks? As companies get nervous about what lies ahead, they return less cash.
  • How will the risk-free rate (10-year Treasury bonds), be affected by a flight to safety, fears about the economy, and central bank actions?
  • How will investor risk aversion be affected by fear of a market sell off as reflected in the implied equity risk premium (ERP)?

When valuing companies, create a story to go with your valuation, about how your sector will play out after the crisis and whether your company will emerge stronger or weaker.

  • How will the crisis affect revenues and company operations in the near term?
  • How will the crisis affect the business the company is in and its standing in that business over the longer term?
  • What are the new probabilities for the company’s “Failure Risk”?
  • How will the crisis affect the price of risk and likelihood of default by updating the ERP and default spreads?

Go back to basics and the fundamentals and be willing to live with uncertainty. If you’re wrong, revisit your valuation.

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