My biggest regret as an investor is never about what I have bought; the worst case then would be that I had an absolute dud of an investment — but I could always sell. (Though the truth is that, more often than not, I would wait too long to sell.)
However, as I always remind myself as an investor, my risk is 100% of what I paid, while the upside is unlimited. With a diverse portfolio this means that even the worst buys would leave only a scratch, not a gaping wound.
For me the biggest problem is not buying. I spot a stock, do all my research and think it looks great, but then want a lower price. So I wait. All the while the price moves higher. Eventually there is a sell-off, but it retraces to a price that is higher than it was when I first saw the share.
With this in mind I have developed a simple method for deciding if a stock offers value relative to its historic valuation. But I stress, I do this only with high-quality core holdings. It’s not something I do with second-tier or cyclical stocks. They have a different level of risk. For a simple retailer, a financial stock or even a real estate investment trust, this works well.
My first port of call is getting some historical p:e data. Ideally, I want 10 years of data. This isn’t always easy to find; my broker provides it, and there are paid websites where you can get access to it. But you can also do it yourself, manually. This isn’t as bad as it sounds, as you only really need the p:e at every set of results, because that’s where a newly updated headline earnings per share (HEPS) number, which is half of the earnings multiple, can be found.
Once I have all the data on an Excel spreadsheet, I work out the average for that period. I now have a 10-year average p:e for the stock. I compute one standard deviation below the average to get my main data point.
What I do then is take the forward p:e, which uses the current share price together with the next year’s expected HEPS, which can again be found from consensus data. Or I can just increase the current HEPS by their average HEPS growth.
I developed a simple method for deciding if a stock is offering value relative to its historic valuation
When the forward p:e is about one standard deviation below the 10-year average multiple, the stock is, in my books, offering value, and I’ll buy.
Doing this doesn’t mean I am going to be buying at the bottom; any stock can fall more than I expect. It is also not foolproof, as the forward HEPS may be completely wrong — or maybe the average multiple in the future will be lower.
But I have run such sums over the past 15 years, and more often than not this has given me a great entry into a high-quality stock.
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