Valuation - The Odds and Ends

After three posts about DCF analysis, you may be under the impression that is the only way I value stocks. While I certainly like its mathematical logic, one needs to be vary careful with its inputs, it doesn't work nicely in all scenarios, and usually isn't possible to do on the spot. Time to explore some other approaches. 

It may come as a surprise to learn that less than a third of all businesses listed on the ASX made a profit last year. Valuing the other two thirds on an earnings basis is quite difficult. I generally stick to researching profitable companies, but there is certainly value to be found in some loss making businesses if you compare their market value to the equity or net tangible assets (NTA) that they have. The logic is intuitive: if a business is selling for $100 million on the share market, and it has $200 million of equity (assets minus liabilities) on its balance sheet, how can you go wrong?

Indeed, Benjamin Graham, the father of value investing, employed a similar balance sheet technique known as his 'net-nets' approach: 'The type of bargain issue that can be most readily identified is a common stock that sells for less than the company's net working capital alone, after deducting all prior obligations. This would mean that the buyer would pay nothing at all for the fixed assets - buildings, machinery, etc., or any goodwill items that might exist.' He aimed to buy stocks that were selling below two thirds of their net working capital (an even more conservative measure than NTA), reasoning that a group of stocks adhering to such a strategy would produce results that are 'quite satisfactory'. Graham's performance was certainly satisfactory, but he achieved it in an environment where information was hard to access and stocks were more often neglected. Nowadays, finding a net-net is rare and these businesses are often only priced cheaply because they are plagued with severe problems, so such a strategy is limited in its application. However, outside of Australia, some stock exchanges offer a return to the net-net days - I hear Japan is good hunting ground at the moment. 

Although I recognise that buying net-nets or stocks significantly below their NTA has proven to be a valid and successful approach, I don't like to view every business through this lens of liquidation value with the mindset that they will go broke soon so investors can get their hands on those assets (unless of course, they are actually going bankrupt and there is a mispricing). Most businesses that look very cheap compared to their current NTA are haemorrhaging cash, so you could be waiting a long time before the market revalues the stock, and in the meantime NTA is evaporating. Another danger is that the assets on the balance sheet may not be quite as tangible or valuable as they seem if the business were forced to sell, perhaps due to bankruptcy. Personally, I don't have the skills or confidence yet to determine what assets would be worth under a fire sale scenario. Instead of this rather stagnant outlook, I prefer to buy compounding businesses, and the only way to compound money is to be earning it, hence my emphasis on earnings over the balance sheet for valuation purposes. This doesn't mean I wouldn't make exceptions if I thought an NTA situation was particularly attractive, but these investments would be the minority. 

As time goes on, I've increasingly favoured the simplistic measure of the price/earnings ratio (P/E ratio) and its reciprocal, the earnings yield. I know there many value investors who object to the P/E since it assumes current earnings are forever maintained and doesn't account for a host of other important factors, but it provides a very rough indication of whether something is cheap or overpriced, and that's all I really need. I'm not interested in buying stocks that are trading 10% or 20% below a calculated intrinsic value, instead I like to wait for the fat pitch, where I believe there is a high likelihood of doubling my money or more over a 5 year period (ie at least a 15% pa return). For instance, if a business is sound and its normal earning power puts it on a P/E of 5, no DCF is necessary. Looking at this example from an earnings yield perspective, if you owned a business that could pay you a 20% return from day one, and these earnings were sustainable, it's a no brainer. There's a large margin of safety just from looking at it. At the 1996 Berkshire Hathaway Shareholder meeting, Charlie Munger noted: 'Warren talks about these discounted cash flows. I’ve never seen him do one.' 'It’s true,' replied Buffett, 'if the value of a company doesn’t just scream out at you, it’s too close.' 

So after all that effort discussing DCF analysis, was it worthless? Well, I don't think so. While accessible measures like the P/E ratio provide rough clues as to the true value of the business, DCF yields the actual answer. In practice, I can generally decide very quickly whether a particular stock is a bargain or not just by looking at its P/E, but confirm this initial conclusion by doing a DCF valuation. By understanding how intrinsic value is derived from a DCF, further pitfalls of the P/E ratio can be gleaned and addressed. For instance, although many companies trade on a low P/E, DCF tells us that unless earnings are maintained and are reinvested at a decent rate of return on equity, these businesses may not be as cheap as they appear. This is often the case, so keeping such caveats in mind enhances the usefulness of the P/E ratio rather than blindly buying stocks with the lowest P/E. Another added benefit of the P/E is that it can be used to crudely test a whole range of scenarios very quickly in your head. For example, if you think earnings per share are likely to be between $1.80 and $2.00 in a few years time and that when compared to peers or the market, a P/E multiple of 10 to 12 is reasonable, the share price range is anywhere from $18 to $24. If the most conservative outcome of $18 still produces a good return, then investors may favour purchasing the stock. 

Aside from the P/E, there are many other simple value indicators that may be helpful for investors, including the price to book ratio, enterprise value, and free cash flow multiple/yield. But this final post wouldn't be complete without a quick trashing of another popular metric used in valuation. This time it's the EBITDA multiple, which stands for 'earnings before interest, taxes, depreciation and amortisation'. I can see why managers routinely choose to focus on EBITDA to make their acquisitions and their own numbers look better, but it is beyond me why investors would also choose to ignore these very real costs. Sceptics would say a better term for this metric is 'earnings before all expenses'.

In the end, valuation is as much about art as it is science. Having an understanding of how DCF analysis works is important, but even more so is common sense and the ability to stay rational. Investors should realise that assessing risk and predicting the future is difficult but necessary to attempt themselves - although many services offer to crunch numbers and value every stock automatically, no computer program can incorporate the multitude of qualitative judgements that good investors can. As Munger once said, 'People calculate too much and think too little'. I hope some of the ideas presented have made you think a little more. 

Valuation - The Discount Rate

While I said that this post would be my last about valuation for the time being, as I was halfway through writing it I realised I would only have space to talk about the discount rate here, lest this turn into a long boring essay (I'm afraid it has). So I promise that my next post will be the last. It will also be the last for a while, as I'll have my trial HSC tests coming up. Without further ado, here it is:

As I covered earlier, DCF valuations are quite sensitive to the cash flows that an investor projects. They are also very sensitive to the discount rate, or interest rate used, so getting both right is important to coming up with an intrinsic value. Unfortunately, I don't know what the proper discount rate to use is for each and every business so I can't come up with a proper intrinsic value, but that doesn't rule out the usefulness of DCF analysis for me. Let me explain...

Depending on who you listen to, experts will either tell you that the discount rate should be 'risk free rate' (due to their low perceived risk, long-term government bonds are usually taken as a proxy), or more commonly they'll say that the discount rate needs to incorporate a 'risk premium' on top of the risk free rate (to compensate investors for the extra risk in buying assets such as shares). Determining the risk free rate is quite easy - according to Bloomberg the yield on Australian government bonds for a 15 year maturity is currently around 4.2%. But the risk premium isn't so conveniently found through a Google search. 

In the 1960s, finance academics attempted to overcome this issue (not that they had Google) of the lack of an easily calculable discount rate, and came up with the capital asset pricing model, or CAPM for short. Basically, the CAPM's risk premium is the market premium (or equity premium in the case of stocks) multiplied by the beta of the asset. In my opinion, the first number is on shaky ground, while the second is downright useless for the purposes of valuation. I've read quite a few papers that attempt to estimate the equity premium - which is the excess return of the stock market over the risk free rate - from historical results and get the impression that it isn't as simple as it would seem. Depending on what timeframe you select, whether you use an arithmetic or geometric mean, and whether you include franking credits, Australia's equity risk premium seems to be anywhere from 2% to 7% (it also differs country to country). That's too large a range to be useful in accurately valuing stocks. Some argue that a forward looking equity premium is a better way to do it, but as with most forward looking estimates, they too are subject to wide variations. And others argue that it doesn't even exist at all (see here). 

But even if you look past the dubious nature of the equity premium, it is the inclusion of beta that really ruins the CAPM. Since not all stocks entail the same level of risk, the CAPM attempts to quantify the risk of a particular stock through its beta. You can find this number for any stock quite easily on most financial websites. Beta is calculated by measuring how volatile the share price of an individual stock is when compared to the stock market as a whole. A beta below 1 indicates a relatively steady share price in comparison to the market and thus is less risky, while a beta above 1 signals more volatility and more risk. 

As I explained in my earlier post, How Many Baskets? measuring the risk of a business through its share price volatility just doesn't make sense at all. Every successful value investor knows this is obvious, take Seth Klarman who wrote in his book Margin of Safety: 'I find it preposterous that a single number reflecting past price fluctuations could be thought to completely describe the risk in a security. Beta views risk solely from the perspective of market prices, failing to take into consideration specific business fundamentals or economic developments. The price level is also ignored, as if IBM selling at 50 dollars per share would not be a lower-risk investment than the same IBM at 100 dollars per share.' And he goes to point out more flaws about beta but I hope you can see that it is not a measure of business risk at all. The whole foundation of the CAPM is deeply flawed too, relying on plainly unrealistic assumptions from the efficient market hypothesis (EMH) - for example, that every investor is always rational and risk averse, taking into account all possible information available at the same time as everyone else. Any of the countless financial bubbles and crashes in human history indicate otherwise. 

And can you believe that three of the men that devised the CAPM won the Nobel Prize in Economics for it? Furthermore, the CAPM and EMH are still taught as financial theory in business schools all over the world today. I can see why this is so - when mathematically gifted people turn to the field of economics, they naturally want to come up with elegant, precise formulas just like physics but eventually get carried away with this ambition and end up neglecting reality. As a final potshot at the CAPM, James Montier, author of Behavioural Investing, has suggested that the CAPM be renamed CRAP for 'completely redundant asset pricing'. I wholeheartedly agree. 

After that long rant about the popular CAPM explaining why it should be laid to rest, it's about time I got around to how I approach the discount rate. For DCF valuations I currently use two methods in tandem:

1. I use a single discount rate across all stocks which very roughly incorporates the risk free rate and an estimate of the equity premium. If you were to only discount cash flows at the current risk free rate of 4.2%, just about every stock would seem grossly underpriced, so I justify using a higher rate by fuzzily thinking that the additional amount needed for reasonable valuations must be the equity premium. In the present low interest rate environment, I'd be inclined to use a discount rate around 9 or 10% (yes this is very arbitrary but it doesn't really matter as I'll explain). Of course, using the same discount rate across everything doesn't adjust for the different risk of each stock, so I attempt to incorporate this risk through my projections of the business' future - I use more conservative assumptions for businesses I deem to be risky. Getting a feel for this risk is something that must be learned through practice (and I am still very much learning) but things such the business model, competitive landscape, debt/equity ratio and historical profitability provide some insights. Beyond a certain level of risk, I'm unwilling to attempt a valuation. 

Although I don't pretend this approach produces a proper intrinsic value per se, it does provide a relative measure of value across stocks. Therefore, one can rank dozens of stocks on this 'relative' intrinsic value, and simply purchase the cheapest ones. This seems to be in accordance with what Warren Buffett reportedly said at the 1998 Berkshire Hathaway meeting: 'In order to calculate intrinsic value, you take those cash flows that you expect to be generated and you discount them back to their present value – in our case, at the long-term Treasury rate. And that discount rate doesn’t pay you as high a rate as it needs to. But you can use the resulting present value figure that you get by discounting your cash flows back at the long-term Treasury rate as a common yardstick just to have a standard of measurement across all businesses.' (Please note, as far as I know Buffett hasn't been very specific about discount rates and how he adjusts for risks in writing. Oral quotes such as the one above are often conflicting - some suggest he does actually adjust discount rates but I suspect he's been misquoted in some instances. If you'd like to see more comments from him about the discount rate, including the one I conveniently chose, check them out here.)

2. My second approach is to use a constant discount rate of 15% no matter what level interest rates are and purchase stocks whose share prices are below that estimated value. Since the discount rate is essentially the required return that an investor desires from investing in something, personally I would be satisfied with a 15% annual return over the long term. While the first method provides a relative measure of value, blindly following that would see me continuing to buy the 'cheapest' stocks even in an environment when stocks in general are extremely overvalued, as can happen from time to time. Hence, this second method provides an absolute benchmark of value - if nothing offers a prospective return of 15%, then the stock market is probably overvalued and it may be time to sit out for a while. 

In practice, it wouldn't make much difference if I exclusively used the second approach as both a relative and absolute measure of value. Raising the discount rate by a few percent doesn't change the relative attractiveness of a group of stocks dramatically (higher discount rates favour stocks with cash flows closer to the present and vice versa with lower discount rates), although it will result in dramatically lower intrinsic values. Likewise, I could probably get away with only using the first method and just employing some common sense to figure out when stocks are exceptionally overpriced. 

So in conclusion, by using a constant discount rate DCF analysis enables me to determine which stocks are the cheapest, without actually coming up with a true intrinsic value (although I'd love to be able to). In any case, my inability to decisively determine what the discount rate should be doesn't preclude other investors from doing so - I'm sure someone else has a more logical process. And whatever you do, remember that the CAPM is total crap!

Valuation - The Cash Flows

Just a preamble: if you are unfamiliar with discounted cash flow analysis, I anticipate much of the following discussion will be about as clear as mud, so don't get too concerned if I don't sound very coherent here.

Whilst DCF analysis is often used to value income producing assets like shares, it does have a number of flaws or weaknesses that individuals must be aware of. Most of these stem from the accuracy required in making predictions about the future and the sensitivity of DCF analysis to relatively small adjustments. As the popular saying goes, 'It is difficult to make predictions, especially about the future'. Hence, unless you have enough confidence to make reasonable guesses about the future of a business, one should just put it in the 'too hard' basket and move on.

There are however, a couple of remedies for the inherent sensitivity of DCF valuations. By testing a range of assumptions instead of just one scenario, investors can get a feel for the best case and worse case scenarios. If even under the worse case scenario, the valuation doesn't seem too bad, then you might decide to buy. Alternatively, some like to be very conservative in all their assumptions and thus while they may miss out on opportunities for being overly cautious, they also avoid buying overvalued businesses.

I'd just like to discuss something that has bothered me about the way many professionals go about DCF valuations but is rarely pointed out. Many will tell you that you need to discount 'free cash flows' (essentially operating cash flow minus capital expenditure), I beg to differ. Firstly, if you want to get the true cash flows that a business earns, then you need to subtract the capital expenditure required to maintain the business. Capital expenditure for growth is lumped together with maintenance capital expenditure in the financial statements, making it difficult to determine maintenance capex for businesses that are growing (which is the majority of businesses), and unfortunately management rarely estimate it for investors. In most cases, that's too hard, so the total capital expenditure figure is used, or otherwise earnings are used as a proxy for free cash flow.

More importantly, even if you can get this free cash flow figure, it doesn't make mathematical sense. Let's look at an example of a hypothetical scenario. Suppose a business earns a return on equity of 10% and continues to earn 10% on any retained earnings. It starts out with $10,000 of equity and therefore earns $1000 in the first year (also assume that for this business, free cash flow = earnings). If there are 1000 shares on issue, that equates to earnings per share, or free cash flow per share of $1.00. If it pays out 50% of its earnings as a dividend, earnings will increase at a rate of 5% per annum (so will equity, dividends and intrinsic value) as you can see in the table below.

Assume also that the discount rate, or required return of the investor is 10% (I'll discuss this further in my next post). If I discount the earnings per share every year as you can see in the 'Discounted earnings' column, they eventually approach zero. To come up with an intrinsic value, one just needs to add all of these discounted earnings into infinity, in this table, I've just used the Gordon growth model explained in the previous post to keep things short (only 10 years are displayed) and easily calculate an intrinsic value for each year. In the first year, we come up with an intrinsic value per share of $21.00. Sounds fairly reasonable.

Now, what if we discounted not earnings or free cash flow, but dividends as some investors advocate? Since the dividends are half of this business' earnings, dividends per share in the first year are $0.50 in the new table below. Reapplying the discounting process to the dividends, we get an intrinsic value of just $10.50 (incidentally, this is equal to the equity per share at the end of the first year). So which one is the correct value?

To sort this conundrum out, let's say we have investor A, who buys 400 shares of this business at the end of year 0, when he calculates the value of the business as $21.00, for an initial investment of $8400. Investor B does the same, but at her calculated value of $10.50, for an initial investment of $4200. At the end of the first year, they both receive their dividend, and decide to invest that money at their required return of 10%. While they could invest it anywhere else at 10% and the end result would be the same, let's also conveniently assume that the share price always trades at its intrinsic value (which should give a return of 10% if the intrinsic value is correct) and both investors decide to purchase more shares each year with their dividends.

As is visible in the two tables above, at the end of year 10, investor A ends up with 506 shares and would be sitting on an investment of $17,313, up from his $8400. This is a return of 7.5% per year, an unwelcome surprise after expecting a return of 10%. Happily, investor B ends up with 637 shares, and an investment of $10,894, for an annualised return of precisely 10%.

Thus, it is evident that discounting free cash flows or earnings overestimates intrinsic value, whilst discounting dividends produces the mathematically logical answer. This is because unless those free cash flows are paid out to the investor as a dividend, the investor cannot treat it as theirs yet, and therefore cannot discount them yet. Those retained earnings are used to boost future dividend payments so discounting free cash flows or earnings is double counting. If you're still unconvinced, consider what happens if this business only paid out 5% of its earnings as a dividend, not 50%. The free cash flow model produces an absurdly high valuation of $219.00, while the dividend discount model remains reasonable at $10.95. No sane investor would pay $219.00 per share for a business that earned $1.00 per share in the last year.

In what seems like an endless circle of problems, discounting dividends is difficult to do for a business that doesn't pay any dividends yet. In this situation, investors may skip the business entirely, try to guess at future dividend payments, or simply discount earnings if that is too hard. But as I've pointed out, discounting earnings or free cash flows overestimates intrinsic value, so it's advisable to add an extra layer of conservatism on top if taking this approach. And what if there are no earnings either? Again, either skip the business, guess at future earnings, or approach the valuation from an equity or net tangible assets (NTA) perspective, which I'll cover more in my next post. Finally, in Australia, not all businesses pay the same level of franking credits so to account for that I would suggest incorporating franking credits into the dividend figures (a little research online will show how).

A few interesting conclusions can be drawn about the DCF model from the example above and by examining how its inputs affect intrinsic value:

1. The further in the future cash flows are, the less important they are to the valuation, even though they may be rising in nominal terms (exhibiting the time value of money concept). Therefore, the job of predicting the future is made a little easier: the most important predictions to make are the ones closest to the present. 
2. As briefly hinted at, a business that perpetually earns a return on equity that is equal to the discount rate/required return is worth exactly the value of the equity itself. This can be useful to approximate intrinsic value for certain businesses in your head. 
3. A business that can earn a return on equity above the discount rate should ideally retain earnings to reinvest them rather than giving into pressure to pay dividends. This produces the highest intrinsic value (which is above the value of its equity). On the other hand, businesses that earn a low return on equity and have no good prospects of raising this should pay out all of their earnings as a dividend to maximise intrinsic value (which is below equity). Management that ignore these principles may show ignorance in 'maximising shareholder value', as they so often espouse. 

In summary: I believe that while some other methods produce similarly rational valuations, discounting dividends is the most mathematically correct way to calculate intrinsic value, but it is very dependent on putting the right numbers in. The next, and final post about valuation (for now at least) will explore the discount rate a little more, other valuation methods, and end with my thoughts on valuation in practice.