Friday, 19 July 2013

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. 

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