Interpreting the Value Line / Reversion to the Mean Valuation Questions

[CRHawk]

I'm an beginning / intermediate investor who relies heavily on ValueLine and Morningstar.

 

I have a few questions.

 

1) I understand that the "Line" on Value Line reports is essentially a regression to the mean valuation.  If we assume that the market is rational when averaged over time the line is a reasonable valuation.  Clearly you still have to do your own thinking to avoid $KO at 30 PE.

 

When I take the average PE they state, average dividend, and a reasonable growth assumption, I can calculate the Dividend Adjusted PEG based upon the mean valuation.

 

This leads to an interesting result.  The average valuation implied DAPEG of something like $NSRGY is 2.57.  For $DIS it is 1.17.

 

If these are the average DAPEG values investors are buying at over time, doesn't that mean there is a HUGE premium put on the stability/dividend of $NSRGY? 

 

It seems to me that if I tended to buy when stocks drop below the Value Line aren't I *much* better off buying low DAPEG stocks like $DIS, $CVS, $SBUX, $SHW, $NKE rather than high DAPEG stocks like $KO, $PEP, $UL, $NSRGY?

 

Is this just the effect of investors reaching for dividend yield, or does the market know something I don't?

 

 

2)  Using reversion to the mean valuation implies the business is running at a fairly steady state - growth isn't changing. 

 

If I wanted to know if growth was slowing for a company like $SBUX or $NKE, what would I look for?

 

 

3) I know that using a reversion to the mean valuation isn't as useful for cyclical companies, very new companies, or companies that are more interest rate sensitive like REITs.  I'm okay with that.  I also avoid trouble by leaning towards high moat companies and low debt companies.  I have enough sense to stay away from $KO trading at 30 PE even if that is the current Value Line. But is there something else I'm missing with my approach?

 

 

4) Reversion to the mean seems to imply something else interesting.  Let's say you have two stable growth stocks.  One "should/usually" trades at 15 PE, and another that trades at 25 PE.

 

You can use DAPEG to value them.  But if they tend to revert to the same PE, shouldn't you value them as (Current Difference from PE average) + (Dividend) + (Growth)?  Meaning the *absolute* PE doesn't really matter?  Only the difference from the average PE?

 

[LongHaul]

Good questions CRHawk! I'll try to answer some of them as best I can.  In the future you may want to have fewer questions at one time as you may get more responses.

 

I'm an beginning / intermediate investor who relies heavily on ValueLine and Morningstar.

 

I have a few questions.

 

1) I understand that the "Line" on Value Line reports is essentially a regression to the mean valuation.  If we assume that the market is rational when averaged over time the line is a reasonable valuation.  Clearly you still have to do your own thinking to avoid $KO at 30 PE.

 

When I take the average PE they state, average dividend, and a reasonable growth assumption, I can calculate the Dividend Adjusted PEG based upon the mean valuation.

 

This leads to an interesting result.  The average valuation implied DAPEG of something like $NSRGY is 2.57.  For $DIS it is 1.17.

 

If these are the average DAPEG values investors are buying at over time, doesn't that mean there is a HUGE premium put on the stability/dividend of $NSRGY? 

 

It seems to me that if I tended to buy when stocks drop below the Value Line aren't I *much* better off buying low DAPEG stocks like $DIS, $CVS, $SBUX, $SHW, $NKE rather than high DAPEG stocks like $KO, $PEP, $UL, $NSRGY?

 

Is this just the effect of investors reaching for dividend yield, or does the market know something I don't?

 

 

2)  Using reversion to the mean valuation implies the business is running at a fairly steady state - growth isn't changing. 

 

If I wanted to know if growth was slowing for a company like $SBUX or $NKE, what would I look for?

 

 

3) I know that using a reversion to the mean valuation isn't as useful for cyclical companies, very new companies, or companies that are more interest rate sensitive like REITs.  I'm okay with that.  I also avoid trouble by leaning towards high moat companies and low debt companies.  I have enough sense to stay away from $KO trading at 30 PE even if that is the current Value Line. But is there something else I'm missing with my approach?

 

 

4) Reversion to the mean seems to imply something else interesting.  Let's say you have two stable growth stocks.  One "should/usually" trades at 15 PE, and another that trades at 25 PE.

 

You can use DAPEG to value them.  But if they tend to revert to the same PE, shouldn't you value them as (Current Difference from PE average) + (Dividend) + (Growth)?  Meaning the *absolute* PE doesn't really matter?  Only the difference from the average PE?

 

1.  I don't know about DAPEG but generally all these simplistic formulas are shortcuts.  The long cut is doing the work and thinking it thru.  Dividends are a headfake.  FCF is ultimately what matters and that comes from earnings. 

 

2.  You can look for YOY growth and see if it is slowing numerically.  The money is generally made or lost in figuring out the sustainability of growth and profits.  That can be nearly impossible or easier for more predictable businesses. 

 

3.  Generally speaking buying companies for less than they are worth is a very sound approach.  Figuring out what they are worth is the trick.  As a starting place looking for cheap stocks below trend valuation on Value Line is great.  I believe Peter Lynch and Henry Singleton did that. 

 

4. I like to figure out why the mean has been the mean and value business using a long term DCF.  I am thinking in absolute terms vs relative (what others might pay).  There can be a ton of risk when you think something is "cheap" because someone else might pay 2x its real value.  I think they call it the greater fool game and all types of smart people play it and lose as someone must lose as that is part of the greater fool game.

 

I was in Vegas recently and it really struck me that tons of people (including on this board) are engaged in heavy gambling for thrills in the stock markets.  Of course it can have the veneer of legitimacy which makes it all the more appealing.

[DooDiligence]

I was in Vegas recently and it really struck me that tons of people (including on this board) are engaged in heavy gambling for thrills in the stock markets. Of course it can have the veneer of legitimacy which makes it all the more appealing.

 

That's a dubious assumption from someone who just returned from Vegas & relies on Value Line.

 

A quick read of Warren Buffets Ground Rules & then a long study of Graham & Dodd might change your opinion on some of the ideas here.

[LongHaul]

I was in Vegas recently and it really struck me that tons of people (including on this board) are engaged in heavy gambling for thrills in the stock markets. Of course it can have the veneer of legitimacy which makes it all the more appealing.

 

That's a dubious assumption from someone who just returned from Vegas & relies on Value Line.

 

A quick read of Warren Buffets Ground Rules & then a long study of Graham & Dodd might change your opinion on some of the ideas here.

 

 

H DooDiligence,

 

Perhaps I should of phrased it as some are gambling.  There are all types of investors and speculators.

You can dig into what Buffett, Munger and Graham have said about gambling/speculating in the stock market. 

 

[DooDiligence]

I was in Vegas recently and it really struck me that tons of people (including on this board) are engaged in heavy gambling for thrills in the stock markets. Of course it can have the veneer of legitimacy which makes it all the more appealing.

 

That's a dubious assumption from someone who just returned from Vegas & relies on Value Line.

 

A quick read of Warren Buffets Ground Rules & then a long study of Graham & Dodd might change your opinion on some of the ideas here.

 

 

H DooDiligence,

 

Perhaps I should of phrased it as some are gambling.  There are all types of investors and speculators.

You can dig into what Buffett, Munger and Graham have said about gambling/speculating in the stock market.

 

I'm currently reading Graham & Dodd & am actually on that exact chapter.

 

Sorry if my post was a bit, well, dickish...