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Simon Erickson explains how fundamentals, valuation multiples, and dividends are crucial to beating the market.
The overall returns of stocks typically boils down to three things: Fundamentals, valuation multiples, and dividends.
Regarding the first of those, great companies will find ways to continue to win. They’ll continue to grow their revenues, earnings, and cash flows in ways that benefit shareholders.
Regarding the second, the market will price the stocks of those winning companies as a multiple of those fundamental earnings or cash flows. When there’s optimism, those multiples will expand. And when the going gets tough, they contract.
In my investing, I tend to look for the market giving us a “good deal” on those multiples, especially when compared to their historical norms. Even if a stock price keeps going up, it could be selling at a lower multiple of the underlying fundamentals.
So when I’m deciding on by Top Stock idea each month, there are a few important valuation multiples I always screen for:
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Enterprise Value/EBITDA
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EV/Forward Sales
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Price/Sales Ratio
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Price/Cash Flow Ratio
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Price/Earnings Ratio
If we see any of those contracting over time — ie. EV/EBITDA or P/Cash Flow is decreasing — it could be a signal the market isn’t appreciating the company’s strong fundamental growth.
Companies and even entire industries are also different, so I’m always careful to keep context in what I’m looking at. For fast-growing, recurring revenue software companies, a comparison of EV to forward billings might be a good metric to evaluate. For mature retailers with steady businesses, Price/Cash Flow or dividend yield might be more appropriate.
At the end of the day, valuation is a tool and not a final answer. Though when great companies go on sale for a bargain, I think that’s a signal of upcoming market outperformance.
