Price-to-earnings ratios getting inflated

When investors start to lose their discipline and begin chasing stocks, you might start to notice P-E ratios are getting inflated. The long-term average for P-Es (based on operating earnings) since 1988 has been 18, so when you notice a company’s P-E get dramatically higher than that you’ll want to take notice. You’ll want to analyze a stock’s valuation, including its P-E and PEG ratios, to get an understanding of how rich the price is.

If you’re interested in trying to figure out when an individual stock’s P-E is starting to get lofty, one approach is suggested by BetterInvesting, a large group for investment clubs. BetterInvesting provides electronic software and paper forms that help you measure how lofty a stock’s P-E is relative to earnings forecasts and its historical P-E. A stock is considered to be a “buy” when its P-E falls into the lower one-third of its historical range. Stocks are considered a “sell” when the P-E lands in the upper one-third of the historical range. The methodology gives you a way to evaluate P-Es using a company’s historical valuation.

Dividend yields sagging

A stock’s dividend yield, or annual dividend divided by the stock’s price, can give you a heads-up on a stock that may be part of a bubble. When a stock’s dividend yield drops well below the average in its industry, or what’s paid by other companies, you might start to wonder whether investors are paying up too much for promises. Similarly, you might be suspicious if one company is the only one in an industry not to pay a dividend.

The more investors pay up for a stock, the more the dividend yield drops, because the denominator of the calculation gets bigger. This mathematical reality makes the dividend yield a decent indicator to pay attention to. You can look up dividend yields paid by other companies to see what the norm is.

Dividend yields often get very low when investors get too bubbly about the prospects of the stock market, as they did in 2007, 2000, and 2021, as shown in Table 18-3. Annual dividend yields have been 2.5 percent, on average since 1988. If the dividend yield falls dramatically below 2.5 percent, that’s a red flag to pay attention to.

Don’t assume, though, when the market’s — or a stock’s — dividend yield gets unusually high that it’s a screaming buy. When a stock’s dividend yield gets very high, that may be a signal companies in general — or the specific company — is about to cut the dividend or run into some serious financial difficulties.

Price-to-book ratios skyrocketing

If you ask an investor and an accountant how much a company is worth, they’d approach the question very differently. The accountant might start counting up all the assets, or things the company owns, and subtract all its liabilities, or things it owes. By subtracting the liabilities from the assets, the accountant would come up with the book value of the company. That, the accountant would attest, is the company’s value.

Investors, though, approach the valuation question very differently than accountants. Investors might try to figure out how much someone else would be willing to pay for the company. The price at which a company would sell, the investor might say, is how much the company is worth.

What happens when the accountants and investors disagree? You’ll see it in the price-to-book ratio, which is covered in more detail in Chapter 8. If investors and accountants agree on the value of a firm (which they rarely do), the stock’s price-to-book ratio will be 1. If investors think the company is worth more than what the accountants are saying, the price-to-book will be greater than 1. If investors think the value of the company is less than what the accountants claim, the price-to-book ratio will be less than 1.

When you see a company’s price-to-book soar, it can be a tip-off its stock is in a mini-bubble. GameStop, for instance, was a “meme” stock that could do no wrong in the eyes of many individual investors in early 2021. Investors were enthusiastic about the video-game seller’s plans to expand into new areas like digital collectibles and digital downloads. Investors drove the company’s average price-to-book ratio of just 1 in the third quarter of 2020 to a high of 68 in the first quarter of 2021, as shown in Table 18-4. Investors, though, found out the hard way that buying pricey stocks can be dangerous.

Shares of GameStop started to crack in January 2021, losing nearly half its value by the end of the quarter — a big shock for investors because all the online boards where the stock was being hyped promised it would head “to the moon.” Things got downright ugly by late 2022 when the stock crashed another 40 percent, down to roughly $27 a share.

Here’s one of the biggest problems with using fundamental analysis to avoid big stock declines: timing. Stocks’ valuations can remain inflated for some time and correct with little warning. Consider GameStop. In the December 2020 quarter, the company’s price-to-book ratio already shot up north of 2. Despite the higher valuation, the stock still proceeded to jump more than 1,700 percent over the following quarter. The comeuppance didn’t hit until later that quarter and year and got downright brutal in 2022. This is another reason why no single fundamental indicator can be completely relied on. With GameStop, other forces were at play. Investors coordinated their buying using online forums like Reddit. Additionally, many professional investors “shorted” the stock. By shorting the stock, traders would make money if the stock fell. But if it rose, those “short” investors would lose money. And, ironically, the only way to stop losses from expanding was by buying the shares. That so-called “short squeeze” resulted in even more buying of GameStop. And so, yes, it did go to the moon, until reality of valuation caught up with it. It’s another reason why, many investors, stymied by the timing needed to pick stocks, may be best off simply buying and holding a diversified basket of many stocks.

Profitability becomes meaningless

When you start noticing shares of money-losing companies shooting up to the stratosphere, like GameStop, it’s time to be on bubble watch. A company’s fundamental value is based on its earnings and cash flow. So, if a company doesn’t have any earnings, it doesn’t have any fundamental value. If your fundamental analysis work tells you a company could justify its valuation — that’s one thing. But if you don’t think a company can ever generate profits, you should steer clear even if the stock is rising.

Swelling accounts receivable

If you start seeing the accounts receivable item on the balance sheet skyrocket to the point where it’s outpacing revenue growth, that can be a bad thing. The accounts receivable line item grows when a company sells product to a customer, and accepts an IOU in exchange. If you see accounts receivable growth outpacing revenue growth, you might wonder if the company is pushing product onto customers to boost revenue. The way a company decides when to book revenue, called revenue recognition, may have a profound influence on its results.

Revenue recognition abuse was especially a problem during the dot-com boom — those were fun times for fundamental analysts, as you’ve probably gathered by now. For instance, Internet software company PurchasePro in late 2000 reported a $13.2 million quarterly jump in accounts receivable to $23.4 million. That should have caught fundamental analysts’ attention, because the company’s revenue was just $17.3 million for the period. The company a year later restated results, and the Securities and Exchange Commission ultimately accused company executives of committing fraud.

Overvalued intangible assets

When you think of a company’s assets and read about them in Chapter 6, actual property the company owns that can be touched or seen probably comes to mind. But those types of assets, called tangible assets, are only one part of what a company owns. Companies also have what are called intangible assets, or items believed to have value that cannot be seen or touched. When intangible asset values are inflated, fundamental analysts might believe a company to be worth more than it is in reality.

Many fundamental analysts completely disregard intangible assets when measuring the book value of a company. Since many of these assets probably couldn’t be sold if the company were to be liquidated, it’s often safe to leave them out of your analysis.

Massive big-bath and “one-time” charges

One commonly used trick by companies is the so-called big-bath restatement. When a company is about to report a poor quarter, it makes the quarterly report really bad. A company’s management writes down the value of assets or pays some expenses ahead of time, which makes the current results look horrendous. But by getting all this bad news out, the company sets itself up for the illusion of a better future. Best of all, some investors automatically look past one-time charges, assuming they’re just unusual events. But the fact is, these restatements can have a profound effect on inflating a company’s future profit growth.

Be especially skeptical of companies, sometimes called chronic restaters, which seem to be regularly declaring big one-time charges. One-time charges are supposed to be just that. If you see them occurring frequently, you should wonder why.

Low “quality” earnings

Accounting rules are supposed to make a company’s financial statements reflect reality and give investors an accurate picture of how the business is performing. For instance, companies are expected to book revenue when a sale is made, not necessarily when cash is received on the sale. Booking revenue this way ensures the revenue is matched up with the costs incurred to generate that revenue.

But this accrual accounting technique, while of merit, can open the doors to manipulation. Companies can push the limits of accounting by padding the financial statements with revenue and earnings that have no connection whatsoever to cash actually received or spent. Companies that do this are considered to have earnings of low quality. The statement of cash flows is a fundamental analyst’s best weapon in finding and steering clear of companies with low-quality earnings. I give you complete instructions on how to perform this quality of earnings detection analysis in Chapter 7.

Increasing borrowing, or leverage

If the bear market and credit crunch that began in 2007 taught investors anything, it’s the danger of borrowing too much. Investors learned the same lesson. Some companies, including Bear Stearns and Lehman Bros., had so much exposure to debt, or leverage, they were unable to hold themselves together when business turned south.

While entirely legal, piling on debt can also distort some of the popular measures fundamental analysts consider when evaluating companies’ profitability. Return on equity, a commonly used financial ratio used to measure the effectiveness of a management team, is especially vulnerable to distortion from the use of debt. You can read about return on equity, and how it’s skewed by debt, in Chapter 8.

Again, nothing is illegal about borrowing, and I’m not suggesting at all that it is. Debt can be a critical portion of a company’s total capital structure, because it tends to be cheaper to borrow than to issue stock. But it’s a crime for a fundamental analyst not to pay attention to the effect of a company’s debt.