‘Discounted Profitability’ and ‘Earnings Power’ are Two Criteria that can help you Choose the Right Stock for your Portfolio.
When selecting stocks for one’s portfolio, people generally select those with a good recent performance. If you too do so, then you are committing a common investing mistake. A stock’s future performance is not related to its past performance. A good performance may either continue, or get better, or else reverse to bad. It is a random phenomenon.
From an investment return perspective, relying on recent price performance in selecting stocks for your portfolio is ineffectual, particularly when you are late to the party. Due to the recent good performance, investors might have hoarded into the stock, driving its price to such an elevated level that it now possesses more downside prospects than upside prospects.
Investors should know that a stock’s prospective return declines as its price rises. Likewise, its prospective return rises as its price declines. I am in no way suggesting that you should shun buying stocks that have performed well recently and embrace those that have performed poorly recently; good can get better, and poor can get worse, too. Good or bad, recent stock performance is not the appropriate criterion for choosing stocks for one’s portfolio.
If the recent past is not a reliable criterion in selecting stocks for one’s portfolio, then, how do we go about selecting stocks that can help us achieve superior returns?
Expected Profitability
Profitability is the principal driver of a stock’s price over the long run. The present value of a stock is the sum of the cash flows the firm is expected to generate in the future. This implies that a stock’s price usually reflects the market’s expectation about its future (expected) profitability, not its current or past profitability.
We can approximately estimate the expected profitability discounted into a stock’s price by doing a reverse DCF (discounted cash flow) valuation on the stock. A firm’s stock price declines if it fails to meet those expectations, and vice versa, the price rises if it exceeds those expectations. We could estimate the likelihood of failing or exceeding those expectations by comparing the expected (discounted) profitability with the firm’s past profitability record or its cost of capital.
So, rather than recent stock performance, a more appropriate criterion for selecting stocks for one’s portfolio would be their discounted (expected) profitability and the likelihood of failing or exceeding those expectations.
First, we use reverse DCF valuation to estimate a stock’s expected profitability. The next step in choosing the right stock for our portfolio is determining the stock’s likelihood of meeting or exceeding those expectations. The right stocks for our portfolio are those most likely to exceed, or at least meet, the expectations discounted into their prices. A stock’s ‘earnings power’ is the factor that helps us to estimate this likelihood.
Earnings Power
Some base their decision to buy or sell a stock on relative valuation metrics such as the price-earnings (PE) ratio or price-to-book value (PBV) ratio. Low PE and PBV stocks are favoured over high PE and PBV stocks.
From a risk perspective, it has some advantages. A low PE stock has limited downside prospects as prices are depressed, whereas prices are elevated for high PE stocks, and therefore when fortunes turn bad, the stock has high downside prospects.
However, the principal limitation of this kind of valuation is that it takes into consideration only the stock’s present earnings and assets. But a firm’s true value is not derived from its present earnings, but from the earnings it is expected to generate over its useful lifetime. So, what matters is not the stock’s present earnings, but its earnings power over the foreseeable future.
A stock with a high PE ratio, usually considered highly valued, might possess high earnings power. When such stocks are valued based on their earnings power instead of their current earnings, they may not appear as highly valued as earlier: sometimes they may even appear attractive.
Similarly, stocks with a low PE ratio, when valued based on earnings power may not appear as attractive as their PE ratio indicates. Therefore, earnings power, not current earnings, is another effective criterion for selecting stocks for one’s portfolio.
But how do we discern a stock’s earnings power – how much it can earn in the future? Although the future is uncertain, we could get an approximate estimate of a stock’s earnings power, aided by certain assumptions. These include assumptions about the stock’s reinvestment rate and dividend payout in the foreseeable future – guided largely by past data.
I wish to invest only in companies that can grow their earnings by at least 15 per cent annually in the foreseeable future (5 – 10 years). This is not a perfect or sure-shot way to select stocks that might deliver superior returns. To me, it is just a good enough method, if practised consistently over long periods, you might have a good chance of coming on top.
Afterthought
People make mistakes despite possessing sufficient knowledge and skill to make the right judgement. It is a human fallibility – an inescapable one. And it is more prevalent in investing than anywhere else.
One common investing mistake is being overconfident in one’s beliefs, skills, systems, or strategies. Everyone, including you and me, being humans, is susceptible to this mistake. The extent of overconfidence will be greater if those beliefs have delivered a few positive results.
Such overconfidence can cause us to overextend ourselves by taking on more than warranted risks. Therefore, it is essential to put guardrails against it. The best guardrail is the realisation and acceptance of our fallibility itself. That is, learn to be comfortable with it, rather than trying to cover it up or eliminate it.
Every time I try to make an investment decision, I affirm to myself that how much time and effort I may have put into it, likely, 70 per cent of the time things won’t work out as I want them to. And it is this awareness that restrains me from committing more than 5 per cent of my portfolio to any single idea, however attractive it may seem at the time.
The same attitude is maintained towards the method that churned out the idea: it isn’t flawless. It is as flawed as I am.
Subscribe
Subscribe to receive the latest content directly in your inbox.
AMN CAPITAL 
One thought on “Choosing the Right Stock for Your Portfolio”