Keeping Valuation Analysis Simple

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Section 1:
The S&P 500

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The S&P 500 Valuation Range (Forward Price / Earnings)

20x 15x

10x

Bad Times

Normal Times

Good Times

Analysis: Over the decades, the S&P 500 has generally fluctuated between 10x and 20x forward price/earnings. There have been years well above and well below these levels, but they were short-lived aberrations. In most scenarios, these are good guideposts to use when analyzing the markets valuation.
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Section 2:
Individual Stocks

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Individual Stocks Trade in a Range: Learn the Cycle

Business fundamentals are very strong; revenue and earnings growth accelerating. Sector in favor.

Business fundamentals are stable. Nothing out of the ordinary.

Peak 20x

Know where the stock is within this cycle to better assess if valuation and business fundamentals are aligned.

Average 15x

Trough 10x
Business fundamentals are weak, slowing or declining earnings growth. Sector out of favor.
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Reasonable Forward P/E Based on Earnings Growth Rates

Analysis: You should be willing to pay more for faster-growing companies. Generally, paying 1.0x the companys EPS growth rate is acceptable. Some experts think that paying up to 2.0x EPS growth is o.k. Note: Paying more than 50x EPS is extreme in any scenario and will ultimately burn you. P/E

35x
20x

15x 10x 8x 5x

Declining EPS

~5% Growth

~10% Growth

~15% Growth

~20% Growth

30%+ Growth

Earnings Growth Rate

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Or You Can Think About Your Stock Relative to the Market

If your company is below-average quality If your company is above-average quality 18x 15x -3x 12x 15x

+3x

The S&P 500 in Normal Times

Relative P/E

The S&P 500 in Normal Times

Relative P/E

Analysis: Most companies are average, but a good management team, a unique value proposition (product), and attractive industry may be reasons for an above-average valuation. The reverse is true for below-average.
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Section 3:
Establishing a Price Target

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Regardless, Always Establish Price Targets So You Can be Disciplined When to Buy or Sell

$18.00
Target Price in Upside Case

$15.00
Target Price in Base Case

$12.00
Target Price in Downside Case EPS Downside Case Base Case Upside Case $1.00 $1.00 $1.00 Multiple 12x 15x 18x Price $12.00 $15.00 $18.00

Analysis: You can further refine the scenario analysis by establishing a different EPS expectations for all three cases (in addition to varying multiples). This adds complexity to the analysis, but is also more realistic since your downside scenario is associated with a negative sentiment in the market, which can be driven by a poor macro environment.

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