Exploring Equity ETF Valuation

Getting Fundamental

Discounted cash flow analysis forms the basis of fundamental valuation. With the DCF approach the value of a stock is not how much someone else thinks it is worth or is willing to pay for it. Rather, the value of a stock is the present value of its expected future cash flows, which are discounted back at a rate that reflects the uncertainty of those cash flows.

As with all models, the information you get out is only as good as the information you put in. Making accurate, or useful, forecasts relies on using sound assumptions. This requires an intimate knowledge and familiarity with a company's business model as well as the competitive dynamics of the given industry and the regulatory environment surrounding it.

By aggregating fair value estimates to the fund level, investors can form an estimate of intrinsic value for equity ETFs, which are simply worth the sum of their constituent parts.

It's All Relative

The popularity of relative valuation stems in part from its simplicity and convenience. Relative valuation estimates the value of an asset by comparing the pricing of similar assets relative to a common variable like earnings, cash flows, book value, or sales. This much simpler and more straightforward method of valuing stocks is most useful as a reference point, or sanity check. Investors should keep in mind that there are limitations to using multiples and that using them in isolation could produce misleading results.

Metrics like price/earnings ratios, or P/E, often contain a lot of "noise." By now we have probably all heard of those infamous special one-time noncash charges that can wreak havoc on earnings statements. But management also has several levers it can play with to "massage" the income statement. For example, the waters can be easily muddied by adjustments to the tax rate or an asset's depreciation schedule. Because earnings can be easily manipulated, many investors prefer using a price/sales ratio. But there are also drawbacks with P/S--namely, it tells you nothing about profitability.

Another common relative valuation metric is price/book value. This ratio can be useful when gauging sectors or industries that tend to have tangible assets, like factories and production facilities. We prefer this metric when comparing banks and financial firms, as the businesses are essentially an assembly of financial assets. On the other hand, it doesn't make much sense to use P/B when analyzing the technology or health-care sectors; P/B fails to reflect intangible assets such as intellectual assets, which are often the lifeblood of technology and health-care firms.

Understanding the shortcomings of various relative valuation techniques is important and should help you make more informed investment decisions.

Using relative valuation multiples on index investments, such as ETFs, introduces another unique challenge. When interpreting valuation ratios for an index, make a note of how the index provider treats anomalies in the data, such as firms with negative earnings, which will impact overall results.

Use the Right Vehicle

Before you go and screen valuations in the equity ETF universe, we should lay out some ground rules. The first step to any good investment requires developing a sound investment thesis. And to boost your chances of success, write it down. Putting the idea on paper and being able to articulate it to others will only help shape and strengthen your thesis.

Also, make sure to select the investment vehicle that most closely aligns with the thesis. ETFs are a great way to implement thematic ideas because the diversification inherent in a fund avoids the idiosyncratic risk of single stocks. On the other hand, picking individual stocks offers the potential for spectacular returns if you believe you have an edge or some sort of special insight into a given company.

For instance, if your tactical investment thesis is based on the success of a particular product, a specific corporate strategy, or estimated synergies from mergers and acquisitions, then investing in the individual stock will be the most effective way to express (and hopefully capitalize on) that thesis. In such cases, you are actually seeking exposure to the firm-specific risks that are diversified away in the ETFs.

However, if you have a more thematic investment thesis, like higher commodity prices in the future will boost profitability for resource firms, an ETF could be the way to go. With the ETF, as opposed to a single stock, we are essentially making a bet that a rising tide will lift all boats. An ETF would also be the vehicle of choice to take advantage of situations where you believe the market has greatly over- or underreacted to a particular news item.

For example, a health-care ETF would have fit the bill if you thought the market was unfairly punishing health-care stocks when reform was introduced and uncertainty skyrocketed. In this case, going with an ETF protects us from the risk of selecting a firm whose internal miscues outweigh the impact of broader industry trends on its performance. A surefire way to a poor investor experience is having the right thesis but wrong execution. Be sure to select the vehicle that most accurately reflects your investment thesis.