Carl Lewis, a former nine gold medal-winning Olympian, once said "Life is about timing." For value investors, timing plays an essential role in the value investing methodology. There's the element of patience that every value investor needs to learn, the willpower not to rush into seemingly appealing yet undeniably risky investments.
Then there's the knowledge and mastery of timing that can boost a portfolio. By simply investing at the right point you can achieve 10x returns. It isn't always easy to learn, but it's a valuable skill every value investor should practice early on to see their portfolios stay healthy and profitable.
3 Value Metrics to Take Advantage of with Expert Timing
Price to Earnings (P/E) Ratio
Recap: Your P/E ratio acts as a measuring stick for comparing valuations across different companies. By dividing a stock's share price by its earnings per share, it determines the value representing how much investors are willing to pay per dollar of earnings.
Using Microsoft and Apple Inc. as examples, let's see how timing (using the P/E ratio) to invest can affect returns.
When looking at the following charts indicating Net EPS from STRIDE (this is your Net Earnings Per Share), we can see price listed up the right hand side, while the EPS is listed up the left, giving you that ratio between price and earnings per share.
The ratio between the left hand and right hand side of the chart is 30:1. The price line (indicated by the dotted black line) indicates when the P/E ratio is either 30:1 (when the blue line and dotted line intersect), or when the earnings you’re buying are either cheaper in relation to the earnings (black line dipping below the blue) or the more expensive the earnings are (black line rising above the blue).
When you look at Microsoft’s chart, we can see in the early 2000s that the P/E ratio was way above 30:1, as the price line is far above the earnings line. A gap like the one demonstrated above in red is a key indicator that you’re paying a really high price for earnings, which is not a great place to be.
And yes, perhaps you may look at the chart as a whole and say “But look, I paid far less for my shares in 2000 than they cost currently", but look at how long it’s taken for this to become a reality. Seventeen years, during which you’ve barely doubled your money.
In contrast, let’s look at the point where the P/E ratio was at its lowest, with the price line being well below the earnings. We’ll indicate this point in green. At this point, you’re only paying 10x earnings. Now it’s important to note that while Microsoft has traded fairly consistently close to the 30:1 ratio, there is a period, between 2006 and early 2015 where despite their high earnings, their pricing remains relatively low in comparison.
This “unloved” period is the sort of disparity value investors need to look out for, as investing at the right time here magnifies your returns – this is practically the definition of value investing.
If you’d invested at the green line point, right now you’d be looking at a 300% return in far less time (in this case, around a six-year period). That’s a huge difference to buying at the red line point, where across a seventeen-year period you’d only have received a 50 – 70% return. Same company, different time, massively different returns.
If we look at Apple Inc.'s chart (ratio of 20:1), we can see the blackline staying close to the blue, until an interesting point when the earnings hit $6.31 (purple line). That's the last full year earnings, and yet the price drops, and even though the earnings took a slight dip, investing at the green line would have still seen you paying just 10x earnings. Now, if you'd bought at the purple line mark, you'd still have been below the 20x point, but you'd be pretty close to the earnings – buying at the green line again sees you achieve nearly a 300% return. Clearly, buying the dip on a company that is consistently growing is working for you again.
Price to Free Cash Flow
Recap: Calculated by dividing marketing capitalisation by free cash flow, this metric makes it possible to compare market price to the level of free cash flow a company has on an annual basis. The higher the calculated measure, the more expensive the cash flows.
The first thing to note on the above chart is that the ratio is now around 19:1. We can see that Microsoft traded above 19x free cash consistently, then all of a sudden dipped below in 2008, probably due to the financial crisis. If you look at the 2011 period, you can see a decent gap forming, resulting in cheap free cash flow (indicated by the green line here). During the same period as the P/E chart indicates (around March 2011) we can see that the free cash flow had been growing and growing during their "unloved" period and that they were turning their earnings into free cash. At this point, you've got growing earnings and growing free cash flow and a dropping price. This is the value investing dream scenario.
The ratio with Apple Inc. price / free cash flow on the above chart is now 8:1. So, the closer the black dotted line is to the blue one, the closer you are to paying 8x free cash flow, which is relatively cheap. We can also notice that the free cash flow numbers are higher than the Net EPS numbers in the first Apple chart, so Apple was throwing off free cash at a tremendous rate.
If we take into account both the Microsoft and Apple Inc. charts, we can see that by timing it just right, you can buy in at a point where you have the potential to increase your returns significantly.
Price to Sales
Recap: This metric compares a company's revenues to its stock price, indicating the value placed on each dollar of said company's sales or revenues. This can be calculated either by dividing a company's market capitalisation by its total sales over a 12-month period or on a per-share basis by dividing the stock price by sales per share over a 12-month period. Essentially, it's their total sales per share.
Whether looking at Microsoft or Apple Inc., it's clear both companies have experienced significant growth over the last seventeen years. In the chart below the ratio is around 30:4, which is around 7.5x revenue. While Microsoft's pricing started out well above 7.5x revenue, during that "unloved" period, it's clear that you could have been paying 3x revenue as opposed to 7.5x. Now we have 3 clear indicators that the company is growing while the price is falling. Panacea.
Here we can see a ratio of 60:16, which is around 3.75x revenue, and that the company has pretty much always traded pretty close to that ratio, with the exception of a few rocky spots in the last few years. And you'll note that at the point indicated in green here, you'd have been paying 2.5x revenue instead of 4.5x revenue.
The key here, from a value investing perspective, is to find businesses that are growing their revenue and their earnings, while also considering whether or not those earnings are being developed and reflected in free cash.
And if there's one takeaway, it's the importance of buying cheap earning, free cash flow and revenue at the right time to see your returns expand.
While there's certainly more we can look at than just these three ratios, following the principles above is a good start to developing a successful value plan. Want to know more about value investment ratios? Have a look at this blog we wrote a while back on the six vital value investing metrics. Need more help? Feel free to contact us at any time, we're here to help!