Rational Value: Your Key to Contentment

Many of my posts have referred to rational value. And I’ve been remiss in not making a special effort to define this term for my readers—one I coined several years ago to try to help investors like us keep their minds on what’s important. The significance of this term is that it can keep our feet on the ground when the market is overvalued, and keep our head in the clouds when it’s in the tank. And, on an ongoing basis tell it will us what the reasonable (rational) value of our shares would be.

Rational Value Defined

Simply defined, Rational Value is the approximate value of a share of stock were it to be selling at its rational price—the price investors would pay for it if it were selling at its historical average multiple or “signature PE.”

If you have calculated either the Historical Value Ratio (HVR) or the Relative Value (RV), the simplest way to determine its Rational Price is to divide the current market price by either of those figures.

If, for example, the HVR or RV of XYZ company is 50%, and the current market price were $50, dividing the $50 by .50 would give you a rational value of $100—the price one would pay for it if one were “rational.” So, as you can see, the rational value is the value of your shares when the RV or HVR are 100%.

For those who have not been exposed to either RV or HVR, let me explain and define these terms for you.

Relative Value or Historical Value Ratio

Our methodology is based upon a very basic premise: “Real” investors—those who own stock as part owners of the businesses that have issued it—attach a value to their ownership that is related to the ability of those businesses to earn money and to grow. That relationship between a company’s earnings and the market price of the stock is recognized as the Price Earnings Ratio (PE). [For a more detailed discussion of this relationship and its importance, read "What's a PE and What's it To Me?"] For our purposes here, let’s define the PE simply as the unit price for one dollar’s worth of a company’s earnings.

You can tell if a gallon of gas is cheap or expensive because its price is under or over a “typical” or average price that’s fairly familiar to you. And an investor similarly knows if a share of stock is overpriced or inexpensive, based up what it has typically sold for. Because the price of the shares of a company will vary over time and the PE is relatively stable, we use the multiple of earnings it has sold for—its PE—rather than the price, itself, to judge its value. And that determination is what the HVR or RV provides us.

The RV is a comparison of the current PE with the historical (five-year) average and is calculated by dividing the current PE by that historical average PE. The HVR is similar, except it’s derived by dividing the current PE by the historical (ten-year) median. [The median is the middle value in a series of values and is not unduly influenced by wide swings or outliers.]

That mid-point, however you calculate it, becomes the stock’s “signature PE”—the multiple at which the stock would sell if it were purchased strictly for its earnings performance. By taking the longer term view, we effectively cancel out the short-term ups and downs of the price that are caused by the herd’s whims and guesses. These, of course, are measured—as if we care—by the amplitude of the distance betwen the high and low PEs either side of that mid-point.

It’s the amplitude of the swings either side of that signature PE or mid-point that measure the “rationality” of the price. If everyone were rational; i.e., if everyone were to buy or sell the stock based upon its underlying company’s earnings, the price would be “rational” all the time. However, in times like these, when “irrational despair” prompts the herd to panic and sell its shares, the price of those shares becomes irrationally low. Of course, in the opposite extreme, when the public is “irrationally exuberant,” as former Fed Chairman, Alan Greenspan labled the condition, the prices were irrationally high!

Therefore, the rational price of a share of stock is simply the price that would be paid for the stock if everyone were rational. And, the beauty of this concept is, because the “rational value” is derived from the midpoint of sales and purchases over time, it’s easy to be confident that we will see the price return to that point—and probably overshoot it—when those investors come back to their senses.

Application of Rational Value

The normal cycles in the stock market are caused, in large measure, by the herd’s overshooting in both directions. But, don’t knock it. That’s what makes for the bargains from time to time. It also provides us with an additional opportunity to improve our portfolios’ performances by replacing a position, when it’s so overvalued you can no longer expect a reasonable return on it over the next five years, with one of as good quality but which has a better potential for return.

To sum up, the “rational value,” therefore, is a value of a your holdings to which you can count on your shares returning when the herd comes back to its senses. And that’s the only value you need be concerned about as you perform your portfolio management tasks.

So, sit back, relax, and wait for that to happen. It may take a little longer than usual because the herd is more demoralized than usual; but the value is there, and it will continue to be. Someday soon, we’ll start to see the more intelligent of investors, satisfied that the market has shaken out the last few of its gamblers, backing up the truck and starting to cart off those bargains. And, not long after that, the herd will thunder back, wanting to get on the bandwagon.

  1. Gary Simms
    March 31st, 2009 at 14:36 | #1

    http://finance.yahoo.com/echarts?s=%5EGSPC#chart1:symbol=^gspc;range=my;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined

    Here’s the URL to the maximum history for the S&P 500.

    It clearly shows the long term trend of the stock market or at least of the S&P 500.

    It clearly shows the irrational exuberance of the late 1990′s and the irrational fear present in the market today.

    The problem is that it becomes obvious only in retrospect. Hindsight is 20/20. :-(

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