The foundations, principles and key ideas of value investing
“Rules are not necessarily sacred, principles are.” Franklin D. Roosevelt
We have been discussing the paradox that while value investing is the tried and trusted method of some of the world’s most famous, wealthy and influential stock buyers, for some reason it is still widely overlooked by the majority of institutional investors. We argue that this short-sightedness of the professionals works to the advantage of the motivated and determined individual investor.
But where to begin? Value Investors worldwide disagree on many aspects of investing, but rarely on some fundamental principles:
Price is not value
Mr Market is a crazy guy
Every stock has an intrinsic value
Only buy with a margin of safety
Diversification is the only free lunch
Key Principle 1: Price is not value
The first key lesson for the would-be Value Investor is that the worth of a business is independent of the market price. A stock quote from day to day is only how much just the few shareholders who bother to trade that day decide their investment is worth. It is categorically not the worth of the entire company.
This is the reason share prices so often spike when being bid for by an acquirer, who generally has to pay something closer to fair value. Investors should understand that the share price is like the tip of an iceberg – you can see it, but you’ve no idea how big or small the iceberg is below the surface unless you put on your dive suit.
As Ben Graham observed: “price is what you pay, value is what you get”, meaning that big swings in the market don’t necessarily mean big swings in value. When you buy a stock, you are buying ownership of a business with real assets. Should that really change just because the market is moody or plagued by worries about liquidity? As long as the fundamentals are sound, the daily ups and downs in the markets should not alter the value of what you own.
Key Principle 2: Mr Market is a crazy guy
In Graham’s The Intelligent Investor[1], a book which is required reading for all new analysts at top investment firms, the author conjured his now infamous parable of Mr Market. He asks the investor to imagine that he owns a small share of a business where one of the partners is a man named Mr Market. He’s a very accommodating man who tells you every day what he thinks your shares are worth while simultaneously offering to buy you out or sell you more shares on that basis.
But Mr Market is something of a manic depressive whose quotes often bear no relation to the state of the underlying business – swinging from the wild enthusiasm of offering high prices to the pitiful gloom of valuing the company for a dime.
As he explains, sometimes you may be happy sell out to him when he quotes you a crazily high price or happy to buy from him when his price is foolishly low. But the rest of the time, you will be wiser to form your own ideas about the value of your holdings, based on updates from the company about its operations and financial position.
While some may claim that the markets today are a very different beast to those in which Graham lived due to the dominance of algorithmic trading and risk on/risk off mentalities, the truth is that the extremes of sentiment in stocks and markets are timeless and still evident for all to see – and it’s those extremes that create the opportunity for alert Value Investors.
Key Principle 3: Every stock has an intrinsic value
The critical knowledge an investor needs to take advantage of Mr Market’s behaviour and inefficient prices is an understanding of the true value of a business. The true value of a business is know as its ‘intrinsic’ value and is difficult, though not impossible, to ascertain.
Most investors preoccupy themselves with measures of ‘relative’ value which compare a valuation ratio for the company (perhaps the price-to-earnings, price-to-book or price-to-sales ratio) with its industry peer group or the market as a whole. Inevitably though, something that appears to be relatively cheap on that basis can still be over valued in an absolute sense, and that’s bad news for the Value Investor who prefers to tie his sense of value to a mast in stormy waters.
Intrinsic valuation looks to measure a company on its economics, assets and earnings independently of other factors. But be warned, establishing an intrinsic valuation is not straightforward and there are multiple, contradictory ways of calculating it. We will explain the ins and outs of valuation techniques in the following chapters for those that wish to delve further into the dark arts of valuation.
Key Principle 4: Only buy with a margin of safety
When Warren Buffett describes a phrase as the “three most important words in investing” every investor owes it to himself to understand what it is. The words “Margin of Safety” come from the writing and teachings of Graham and have ensured that his followers have prospered in many market environments. But what does it mean and why is having a large margin of safety so important?
Seth Klarman, one of the modern era’s greatest Value Investors, defines a margin of safety as being “achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck or extreme volatility.”[2]
In other words, once you are certain that you have a fair estimate of a share’s intrinsic value you must only buy the share when you are offered a price at such a discount to that value that you are safe from all unknowns. The difference between the market price and the intrinsic value is the margin of safety.
As Buffett once opined: “You don’t try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principlw works in investing.”
Valuation is an imprecise art and the future is inherently unpredictable. Having a large margin of safety provides protection against bad luck, bad timing, or error in judgment. Given that the investor is using his own judgement, the technique introduces a cushion against capital loss caused by miscalculations or unpredictable market movements (i.e. the value of the stock falls further).
Opinions are divided on how large the discount needs to be to qualify the stock as a potential ‘buy’. Indeed, the bad news is that no-one really agrees on this – for two reasons. First, as we have already discussed, determining a company’s intrinsic value is highly subjective. Second, investors are prepared to be exposed to different levels of risk on a stock by stock basis, depending on how familiar they are with the company, its story and its management.
In his writings, Graham noted that: “the margin of safety is always dependent on the price paid. For any security, it will be large at one price, small at some higher price, nonexistent at some still higher price”. He suggested looking for a margin of safety in some circumstances of up to 50% but more typically he would look for 33%.
Key Principle 5: Diversification is the only free lunch
This is a topic which is so important that we have dedicated an entire chapter to it later in the book. Diversification is incredibly simple to understand and plainly common sense – you shouldn’t put all your eggs in one basket – but in practice (like everything that is supposed to be simple) it seems to be extremely difficult to pull off. The majority of individual investors are massively under-diversified, often with an average portfolio size of only four stocks.
The value investing camp splits into two on this topic. Fundamental value hunters who follow Warren Buffett tend to fall into the ‘focus portfolio’ camp believing that you should put all your eggs in just a few baskets and watch them like a hawk. While it may be true that 71% of the benefits of diversification do come from the first five stocks in a portfolio, this kind of attitude requires a great gift for security analysis and is particularly risky given the high exposure to stock specific disasters – the kinds that value stocks are prone to.
An alternative approach is that espoused by the more ‘quantitative’ value farmers who seek to ‘harvest’ the value premium from the market. As we shall see a little later, in his deep value strategies Graham recommended owning a portfolio of 30 bargain stocks to minimise the impact of single stocks falling into bankruptcy or distress, while Joel Greenblatt recommends a similar level of diversification when following his Magic Formula strategy.
Making sense of value investing principles
In the first article in this guide we discussed how it was good news for individual investors that making money using a value investing strategy requires the mastery of just a few principles. What should be clear now is that while intrinsic value and margin of safety make perfect sense in the context of value stock selection, defining precisely how to execute each principle requires some careful thinking and the acceptance that some nuances can only be decided by the interpretation and preference of each investor.
The Hunter or the Farmer - choose your approach
“It is thought that the changeover from hunter to farmer was a slow, gradual process.” Stephen Gardiner
Over the last hundred years the players in the stock market have had a fairly standard approach to reaping their profit - that of the stock picking ‘hunter’. But in the last 30 years, as the technologies of data handling and computation have improved, a new breed of market player has arrived, the quantitative ‘farmer’ seeking to harvest rather than hunt profits. The last five years have seen such rapid advances in modern technologies that the dominance of the hunter is now seriously under threat. Financially it may pay off enormously to ask yourself whose side you are on.
The Hunter – or fundamental stock picker
Everyone loves to pick stocks - who doesn’t enjoy getting deeply ensconced in the story of a stock and seeing it multi-bag? There’s nothing as wonderful as being right and knowing that you knew it all along. And fortune has followed for the investors who’ve been skilful enough to pick and hold onto the right stocks for an entire career. Such luminaries as Anthony Bolton, Bill Miller or Warren Buffett have become legends in our time as the long term greats of the art.
The classical stock-picking ‘hunter’ will narrow the terrain down to a manageable collection of stocks and start analysing each individually. These kinds of investors have been known to “start at the A’s” and work their way systematically through the market until they find prey worthy of closer targeting. Their primary focus is on the company where they perform in-depth analysis both of its financial situation but also of more qualitative aspects such as analysis of its sector peer group, economic resilience and moat.
Frankly the majority of investors see themselves as part of this group. There is certainly a romantic ideal associated with the hunter archetype which goes so much deeper than just the sheer thrill of the chase. It goes so deep that the fund management group Artemis used the hunter archetype as its marketing emblem for many many years.
The Farmer – or quantitative portfolio investor
There is though a rapidly growing group of investors that are far more interested in ‘characteristics’ than companies who seek to ‘harvest’ systematic mispricings from the rough of the stock market through quantitative techniques. In a stock market that’s predominantly dominated by the far more numerous hunter, these quants have found they have a lot of easy crop. Hunters tend to be a very emotional lot prone to both chasing prey to unsustainably lofty heights and discarding them too hastily aside which allows the quants to profit from their over reaction.
While many think of quants as modern hedge fund employees even the father of value investing, Ben Graham, can be regarded as one. Graham bought up the kinds of stocks you wouldn’t even wish on your mother in law, and seeking safety in numbers. Individually these stocks looked like train wrecks, but collectively they offered him something special - excessively beaten down assets selling at less than their liquidation value which were in aggregate likely to be re-rated.
This approach has been mirrored far more often in recent years by a variety of quantitative techniques such as those espoused in the ‘Magic Formula’, designed to pick up good cheap companies, or the scoring techniques of Joseph Piotroski which aim to highlight companies that have a high probability of turnaround. While these simple techniques (detailed in Part 4) can work well, hedge funds have taken the quantitative model and put it on steroids - targeting all kinds of ethereal areas to profit from that we won’t go into here.
Are the quants winning?
Recent times have seen some star fund managers come crashing down to earth. Many have had calamitous years, some of whom have been blaming an underlying change in the market dynamic. Could it be the terrain of the stock market is being changed so much by the growing dominance of the new quants and collective investments like exchange traded funds that it’s getting far less safe for the traditional hunter?
You don’t have to be a hero…
The financial world, press and media tend to glamorise the approach of the stock picking ‘hunter’ - the Warren Buffetts of the world - which contributes to so many individual investors over- rating their abilities and becoming easy prey of the farmers. The irony and evidence is that many investors really do not have the time nor the resources to perform the kind of analysis that can turn stock picking into a highly profitable activity in this changing market environment.
Under this canopy of persistent underperformance, the first step a recovering stock picker can take is to redefine their approach to their search process. As we should all know tips, TV and brokers tend to funnel naive investors into extremely low probability story stocks, and while this can be a fun ride it often ends all too familiarly. A better approach is to start by applying some proven quantitative criteria to narrow down the universe of stocks to a starting list to pick their stocks from and buying them as a basket.
Be careful not to be a hunter-gatherer…
But even then investors have to be careful. One of the findings in recent years is that individuals who buy individual stocks off these lists will time and again favour names that are familiar to them and shun the strangers. As has been highlighted by Joel Greenblatt, in general they are picking the wrong stocks! If you take the profits of any portfolio strategy, often 20% or more can be attributable to a single stock, which is regularly the least likely of the basket to be chosen by a stock picker!
James Montier, who made his name with a series of famous research papers at Soc Gen, wrote an Ode to Quant, which showed that quant models in many fields (e.g. medical science) tend to provide a ceiling from which we detract performance rather than a floor on which we build. The paper asks whether investors in aggregate might do far better in their stock picking if they essentially gave it up and deferred to the models. As he comments:
“Long-time readers may recall that a few years ago I designed a tactical asset allocation tool based on a combination of valuation and momentum. At first this model worked just fine, generating signals in line with my own bearish disposition. However, after a few months, the model started to output bullish signals. I chose to override the model, assuming that I knew much better than it did (despite the fact that I had both designed it and back-tested it to prove it worked). Of course, much to my chagrin and the amusement of many readers, I spent about 18 months being thrashed in performance terms by my own model.”
While giving up on individual stock picking may seem an extreme proposition, and one opposed to the activities and instincts of the vast majority of investors, there’s a growing body of evidence to suggest that, for many, it could be the smartest and most rewarding choice they can make.
Six essential ratios for finding cheap stocks
“We don’t have to be smarter than the rest. We have to be more disciplined than the rest.” Warren Buffett
With the art of picking lowly valued stocks playing such a central role in any value investing strategy, it is essential for the investor to get acquainted with the necessary tools to make a proper assessment.While not many investors managed to make it to accountancy school, there are a few shortcuts available to understand a company’s valuation and its business quality.
These generally come down to understanding a few simple ratios. The next 2 chapters will focus on how to isolate both cheap stocks in terms of valuation ratios, but also good stocks in terms of their operating ratios.
When an investor buys a company he’s buying the company’s assets but also a claim on the future earnings of that company. As a result it’s unsurprising that the top two things that Value Investors try to do is to buy assets on the cheap or earnings on the cheap.
While some financiers specialise in evaluating these things in extremely complicated ways, plenty of star investors such as David Dreman and Josef Lakonishok have had great success just focusing on the simplest ratios like the P/E Ratio and P/B Ratio which we describe in this chapter.
When using valuations ratios such as these its important to take a couple of things into account. Firstly, investors should compare the ratio for the company in question against the market and the sector peer group but also against the company’s own historical valuation range. By doing this the investor can not only find cheap stocks in the current market environment but also make sure they aren’t being caught up in frothy overall valuations.
There are risks to using these kinds of ‘relative valuation’ ratios that we’ll discuss in a forthcoming chapter, but nonetheless the following six ratios are essential weapons to keep sharpened in the armoury.
Price to Book Value - buy assets on the cheap
The P/B ratio works by comparing the current market price of the company to the book value of the company in its balance sheet. Book Value is what is left over when everything a company owes (i.e. liabilities like loans, accounts payable, mortgages, etc) is taken away from everything it owns (i.e. assets like cash, accounts receivable, inventory, fixed assets).
It is worth noting that this book value often includes assets such as goodwill and patents which aren’t really ‘tangible’ like plant, property and equipment. Some investors remove such ‘intangible’ assets from calculations of P/B to make the more conservative Price to Tangible Book Value (P/TB).
The P/B ratio has an esteemed history. As it doesn’t rely on volatile measures like profits and has a hard accounting foundation in the company’s books, it has often been used as the key barometer of value by academics.
The lowest decile of P/B stocks, similarly to low P/E stocks, have been found to massively outperform the highest P/B stocks by an average of 8% per year highly consistently. Most Value Investors try to buy stocks at a discount to their Book Value – or when the P/B ratio is at least less than 1.
We’ll be looking at several of Ben Graham’s more obscure and arcane ways of buying assets on the cheap in the Bargain Strategies section later in the book.
Price to Earnings Ratio (P/E) – buy earnings on the cheap
Much maligned by many as an incomplete ratio that only tells half a story, the P/E ratio is nonetheless the most accepted valuation metric among investors.
By dividing a company’s stock price by its earnings per share, investors get an instant fix on how highly the market rates it. It is effectively shorthand for how expensive or cheap a share is compared with its profits.
Celebrated contrarian investor David Dreman put the P/E at the top of his list of criteria for selecting value stocks. In a study that spanned from 1960 through to 2010 Dreman found that stocks in the lowest 20% of PE ratios outperformed high P/E ratio stocks by an astonishing 8.8% per year! Not only that but he found that low P/E stocks outperformed in 70% of calendar years. Investing in such a strategy might miss the glamour growth ‘stars’ but who wouldn’t want to place their bets on those kinds of odds!
The ultimate value investor’s take on the P/E is known as the CAPE or cyclically adjusted P/E ratio. It takes the current price and divides it by the average earnings per share over the last 10 years. Sometimes current earnings can be overly inflated due to a business boom so the CAPE gives a much more measured view. Originated by Ben Graham and popular in the blogosphere it’s an excellent part of the value investors toolkit.
The trouble though with the P/E ratio in general is that it doesn’t take a company’s debt into account and, in a value investing situation, that’s a pretty serious shortcoming which makes comparing differently leveraged companies like-for-like almost impossible. This is where the so called earnings yield comes in…
The Earnings Yield (or EBIT / EV) – buy earnings on the cheap
Investors have a tendency to switch off when faced with tricky jargon. So if you’ve made it to this sentence you are doing pretty well. Most investors define the Earnings Yield to be the inverse of the P/E ratio (or E/P) and consider it a great improvement. Why? Because yields can be compared with other investments more easily – for example bonds and savings accounts – whereas P/E ratios are, well, sort of useless for comparing against well, anything… other than other P/E ratios of course. This is most probably why brokers and the media love PE Ratios so much as they are infinitely flexible for ramping stocks up to silly valuations.
But, given that the P/E (and thus E/P) ignores debt – Joel Greenblatt in the Little Book that Beats the Market[3] redefined it to take the debt into account. His definition compares the earnings due to all stakeholders in the firm (the operating profit) to the entire value of capital invested in the firm (i.e. the debt + the equity or ‘enterprise value’).
Just be aware that the earnings yield defined this way is a far better version of the P/E ratio for comparing how cheap differently leveraged stocks are to other stocks and that it’s definitely the right way up for comparing stocks with bonds (which is what a lot of Value Investors like to do).
Price to Cashflow - a good catch all?
The price to free cash flow ratio compares a company’s current share price to its per-share free cashflow. Free cashflow is defined as cash that the operation creates minus any capital expenditure to keep it running. It’s the amount of cash left over which a company can use to pay down debt, distribute as dividends, or reinvest to grow the business.
The benefits of looking at the price to cashflow versus other ratios like P/E or P/B Ratios are several - firstly some companies systematically understate their assets or earnings which can make them harder to isolate with a low P/E or low P/B scan – but secondly earnings and assets can be manipulated by crafty management accountants to make companies appear more profitable or asset rich than they actually are. In Josef Lakonishok’s studies he showed that the return profile of using the P/CF ratio is very similar to the P/B and P/E ratio - cheap P/CF stocks massively outperform high P/CF stocks in almost all timeframes - making it imperative to hunt for low P/CF stocks.
Price to Sales Ratio – No earnings? Buy sales on the cheap
But what do you turn to when a stock doesn’t have any earnings and therefore no PE ratio? While earnings can vary from year to year, sales are much more stable and as a result one of the more popular approaches is to look at a stock’s Price to Sales Ratio.
The ratio was first popularised in the 1980s by Kenneth Fisher in the book Super Stocks and later labelled the ‘King of the Value Ratios’ by another author Jim O’Shaughnessy in What Works on Wall Street. But it really got a bad name when it was misused in the dotcom bubble to justify nosebleed valuations.
But it does remain a key indicator for isolating potential turnaround stocks. Low Price to Sales Ratio stocks, especially compared against their sector, can often be stocks that bounce back very quickly as they return to profitability. Look out for Stocks with historically reasonable margins trading on P/S ratios of less than 0.75 without much debt.
PEG Ratio – Buy earnings growth on the cheap
Popularised by ex-Fidelity star fund manager Peter Lynch and later given a twist by UK investment guru Jim Slater, the price-to- earnings growth ratio, or the PEG, takes the PE Ratio and puts it on steroids. The trouble with the PE Ratio is it is so variable depending on the growth rate of the company. By dividing the PE Ratio by the forecast EPS growth rate an investor can compare the relative valuation of each more comfortably.
It is generally accepted that a PEG ratio of under 0.75 signifies growth at a reasonable price (e.g. PE ratio 20 for EPS growth of 20%) - though be aware that when market valuations fall below average this barometer should be reduced. While the PEG tends to focus on the growth prospects of a stock, which aren’t necessarily vital to a value hunter, it nevertheless gives improved depth to the more simplistic PE for investors that like a bit more bang for their buck.
Horses for courses…
The choice of which of these valuation ratios you will prefer to use will come down to the situation at hand.
Some companies are consistently profitable (use P/E or Earnings Yield),
Some have more consistent cashflow than profits (use P/CF or EV/EBITDA),
Some are losing money on their sales (use P/S),
Others have no sales to speak of but do have hard assets (use P/B)
Others are a bit pricier but are cheap for their growth (use PEG).
By understanding this array of value factors you’ll be far better placed to turn over different stones when circumstances favour it. Don’t be a one trick pony!
Six essential clues to finding good stocks
“It is a capital mistake to theorise before you have all the evidence. It biases the judgment.” Sherlock Holmes
Investors in value stocks are always up against it. If you are buying out of favour stocks then you come to expect some nasties and get used to them. But it doesn’t mean you should go forth blindly. If you can recognise a company with a consistent operating history and good historic business model, you’ll be better placed to ascertain when a stock has simply fallen out of favour, or come upon temporary hard times and therefore profit handsomely when it overcomes the glitch and returns to prior glories.
This is precisely the approach eventually taken by a certain Warren Buffett. As his assets under management grew and grew he became tired of just looking for ‘bargains’. He found more often than not that once a bargain always a bargain. Instead of just looking for any company selling for a cheap price he started to look for great companies at fair prices.
He likened businesses to castles at risk of siege from competitors and the marketplace. Truly great companies are able to dig deep economic moats around their castles that become increasingly impregnable to competition and market pressures. These moats bring either pricing power or cost reductions which help sustain very high returns on capital, leading to higher cashflows and thus ‘satisfactory’ returns for investors.
But where Buffett has been so canny is in recognising when great companies are being marked down by investors for making temporary solvable mistakes – here are some of the clues that Warren Buffett looks for to find great businesses.
Three financial clues of a good company
When a stock picker takes a closer look at a value stock situation it’s essential to look at its operating history. While current numbers may look poor, the clues to a good recovery situation often lie in whether the company used to have a strong business model – here are a few financial clues that it did….
1. High sustainable free cashflow
Great businesses tend to have several things in common. Firstly they make a lot of cash. Cash is the lifeblood of any business and without cash all businesses fail. If a company can’t make cash from its own operations it will have to resort to raising cash from new shareholders (which dilutes your stake) or borrowing money from lenders (which raises the risk of financial distress).
Free cashflow is most easily defined as the operating cashflow less any cash needed to maintain the asset base (known as capital expenditures or capex). Investors should look for companies that are able to generate as much free cashflow per share as earnings per share, and if a company shows a consistent Free Cashflow to Sales ratio of greater than 5% you can be sure it’s a ‘cash-cow’.
2. High sustainable return on equity (ROE)
While the acronym ROE could be offputting to the novice investor, there really is nothing more important. The return on equity shows how much profit a company makes as a proportion of the money (equity) invested in it.
A high sustainable ROE of 12%+ is the engine from which fortunes are made. Why? Because if a company can reinvest its profits back into the company at the same rate of return, that 12%+ return can do its magic again on a larger capital base. If it can do this indefinitely, then the company could be a long-term winner. A 20% ROE sustained for 20 years could turn £1 into £38 if it reinvested all its profits! Now that’s why it’s the engine of fortune!
One should note here that companies can artificially inflate the ROE by just taking on lots and lots of debt which is what many private equity companies do, and it’s why so many investors look at another ratio called the ‘Return on Capital Employed’ (ROCE) which looks at the profit in relation to all the capital used in running the business. ROCE is a much better for comparing companies with differing debt levels, and is used by many stock pickers preferentially – it’s the key component of the Magic Formula which is explained later.
3. High sustainable margins
Great companies are the kings of their domain. As a result they often have significant pricing power – the ability to set higher prices than their peers. The best reflection of this power is in the margin numbers – the profit figure as a percentage of sales.
Margins are very sector specific – for example in food retailing operating margins are routinely very slender at 3-4%, whereas in pharmaceutical companies they can be far higher at 25% or so. But what is constant is that great companies have some of the top ranked margins in their domain.
Three qualitative clues of a good company
Buffett analyses a company’s position in its market to make sure he’s buying companies with a sustainable ‘economic moat’. He wants to buy companies with strong ‘franchise value’ – when buying cheaply you don’t want to be caught with a commodity business. Some of the questions to ask whenever you are evaluating a business include:
1. Has it got impregnable intangible assets?
Intangibles are basically things you can’t see - i.e. Brands, Patents and Regulatory approvals rather than tangible assets like factories or distribution systems. Intangible assets can be unique to companies and deliver fantastic pricing power.
2. Do customers have high switching costs?
Banks historically have been able to charge nosebleed fees to their customers because people just can’t be bothered with the hassle of switching banks. Similarly costs of switching are high for companies or individuals that rely on integrated software - data processing, tax or accounting can be great businesses. A unique kind of switching cost comes when companies benefit from network effects in the use of their products which are immensely sticky.
3. Does the company have cost or scale advantages?
Cost advantages can be sustained for a long time in certain situations - for example when a company has cheap processes, better location, unique assets or scale benefits (such as distribution or manufacturing scale).
While entire books have been written about the qualities of great companies and the brilliance of their management the best quote comes again from Warren Buffett - “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” The truth is that good companies in good industries ought to run themselves – many industries are in terminal decline and no star manager can necessarily save them. When trying to isolate great companies it pays to stick to the financial clues and a few common sense perspectives on their business model.
How to calculate what a stock’s worth
“I conceive that the great part of the miseries of mankind are brought upon them by false estimates they have made of the value of things.” Benjamin Franklin
If you are taking the hunter approach to picking stocks, you can’t just rely on safety in numbers and buying baskets of ‘cheap’ stocks. You have to get to the bottom of what each stock you are looking at is really worth.
But while that’s a pretty tricky thing to do we shall see that there are plenty of ways to get a good enough approximation to buy with the confidence you have a margin of safety.
We all know how to value a house… don’t we?
If you were to buy a house there are two approaches that you could take to estimate its value. Firstly you could have a look around at what other similar houses in the area are being sold for, or alternatively you could ask a surveyor to estimate what it would cost to rebuild the house from scratch – land, materials and labour.
Attempting to value a stock is no different – you can either try a ‘relative valuation’ by comparing any of the ratios we’ve just discussed against its peer group, or you could try to calculate an ‘absolute valuation’ of its intrinsic value.
Both approaches have their merits and their advocates in different market climates but most Value Investors prefer to lean towards absolute ‘intrinsic’ valuations, especially at market extremes. Why? Because relying on what other people pay for something as a barometer of value can lead to some very nasty outcomes.
The joys and dangers of relative valuation
Most investors with any memory can remember what happened in the dotcom bubble when analysts stated that ‘This Time it’s different’ and that it was fine for investors to pay a P/S ratio of 100x for a stock that had any kind of website attached.
“This time it’s different” are the most dangerous four words in finance and ought to send investors running for cover, but for some reason time and again they don’t. Contrary to most markets where rising prices put buyers off (think fruit or electronics) in the stock market rising prices attract investors rather than repel them. When the market as a whole rises, stocks that used to be expensive compared to their peers suddenly find themselves cheap. Investors then pile into these now ‘relatively’ cheap stocks raising their prices higher than their peers thus perpetuating the cycle. This can carry on and on in a self-reinforcing cycle until an inevitable crash brings everyone back to their senses.
But in spite of the limitations of valuing stocks in comparison to their peer group there are many investors that have had much success with the approach. The trouble is that as the great economist John Maynard Keynes once mused: “The Market can stay irrational for longer than you can stay solvent”, which really implies that if you don’t ‘play the game’ when markets are theoretically over-valued you can miss some of the greatest years in the stock market. Pity poor Tony Dye, the famed Value Investor, who predicted the stock market crash years too early and eventually was sacked from Phillips & Drew in year 2000 just before value stocks had their renaissance!
As we’ve seen in recent chapters, a simple strategy that targets the cheapest stocks in the market on a basis (whether by low PE ratio or high earnings yield) can outperform the market as a whole. The benefits of this approach are that you are always in the market so you won’t miss the best years but the drawbacks are several. You’ll have to live with the pain of occasionally buying baskets of overvalued stocks and watching them suffer but you’ll also find that you’ll never be sure of the stock’s value yourself… always looking for validation from others, or god forbid, the market to confirm that the price is right.
Clearly there has to be a better way to value stocks than just comparing them to the market? Ben Graham would turn in his grave if he felt that investors were systematically buying over priced stocks and ignoring his teachings. So yet again we’ll turn to the topic of intrinsic value – and cover several ways to figure out the absolute worth of a stock.
Choosing your weapon… assets or cashflow
There are two main approaches to figuring out an absolute intrinsic valuation for a company. The first is to look at the assets it owns and figure out how much they would be worth either in a sale or if they had be replaced. The other is to look at the earnings, or more specifically the projected cashflows of the company, and figure out how much you’d be willing to pay for the right to own them as an income stream.
In the example of the house we discussed earlier, you would be thinking about the price of land and replacement cost of the building in an asset valuation but you’d think about how much you’d pay for the rental cashflow in the latter.
Ultimately, which approach you prefer comes down to the situation at hand and what your goal is. If you are buying a sustainable business with a consistent operating history then you are going to prefer a cashflow based approach. But if you are going to buy a bargain bucket stock at risk of bankruptcy or an oil stock with no earnings then clearly you are going to prefer the asset approach.
We will be looking in greater detail at asset based valuations when we turn our attention to Bargain investing in a later chapter because it really is a specialist area worthy of its own attention. But because most companies are valued at prices way over their asset valuations, it can be of limited use in all but the more extreme cases.
Discounted Cashflow – it’s all about the cash…
Cashflow is the lifeblood of any business. Not earnings, not assets, but cold hard cash. Cash can’t be manipulated as easily by accountants as earnings or assets and ultimately a cash return in the future is the one thing that investors want when buying a stock. You can either sell the stock for a cash return, or if you hold it indefinitely you can receive a cash income from that investment in the form of dividends for the lifetime of the company. As a result you can value that cashflow in the same way that you might value an annuity.
This methodology is known as the ‘Discounted Cashflow Technique’ (DCF) and is best described by its inventor John Burr Williams: “The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset”.
In simple terms, discounted cash flow tries to work out the value today of all of the cash that the company could make available to investors in the future. It is described as ‘discounted’ cash flow because investors value cash in the future less than they value cash today so it is ‘discounted’ or reduced to a present value by a suitable interest rate.
The calculation is very simple and can be performed on any spreadsheet or using one of the calculators that we’ve made available on Stockopedia. It is best illustrated by an example. If you could buy the right to receive £100 from me in one year’s time, how much would you pay? You’d probably want a better interest rate than you got from a bank as I might run off – so say a 10% rate. You might then be willing to pay £91 in order to receive the £100 back next year which would ensure you got the 10% return on your ‘investment’. The £100 has been ‘discounted’ to £91 today. DCF works in precisely the same way but over multiple years and multiple cashflows.
DCF does have its weaknesses as a valuation methodology. Highly regarded City analyst James Montier argues that: “while the algebra of DCF is simple, neat and compelling, the implementation becomes a minefield of problems”. In particular, he cites the difficulties of estimating cash flow growth rates and estimating discount rates as big areas of concern. Furthermore, small changes in inputs can result in large changes in the value of a company, given the need to project cash flow out forever.
These drawbacks make DCFs susceptible to the principle of ‘garbage in garbage out’ and allow canny analysts to create fancy valuations to back up whatever their view is on a stock – so always be sure to be suspicious when an analyst wows you with the jargon that starts “Our baseline DCF valuation implies that…”
But despite the fuzziness, though, DCF is still the most logical way to evaluate the relative attractiveness of investments and businesses and as should be used in tandem with conservative inputs and a key margin of safety. As part of Stockopedia’s subscription, we provide pre-baked DCF valuation models for all stocks, which you can then modify with your own assumptions.
Ben Graham’s “Rule of Thumb” shortcut
For those struggling with the complexity of the DCF approach, Graham articulated in his book The Intelligent Investor[1] a simplified formula for the valuation of growth stocks which can help by providing similar results: “Our study of the various methods has led us to suggest a foreshortened and quite simple formula for the evaluation of growth stocks, which is intended to produce figures fairly close to those resulting from the more refined mathematical calculations.”
The formula is as follows: Intrinsic Value = Normal EPS x (8.5 + 2 X EPS Growth Rate)
A P/E of 8.5x was therefore Graham’s effective base P/E for a no- growth or ex-growth company. He suggested that the growth rate should be that expected over the next seven to ten years. The formula tallies very closely to a simple ‘two-stage’ DCF calculation over the same timeframe and is an excellent ‘back of the envelope’ technique to keep at hand. Some investors consider this formula too aggressive in today’s low interest rate environment as Graham lived in times of higher interest rates and have reduced the multiple from 2 to 1.5x to create a more conservative set of valuations. This is the approach that we take in our own Graham Formula Calculator on Stockopedia.
One for the pessimists – valuing earnings without forecasts
Given the inherent problems in forecasting cashflow or earnings into the future, and the fact that so many analysts are over- optimistic, some Value Investors argue that there’s a better way to analyse stocks than the DCF analysis which typically relies on speculative growth assumptions many years into the future.
‘Earnings Power Value’ is a technique gaining many fans which has been developed by Bruce Greenwald, an authority on value investing at Columbia University in the US which assumes a zero growth rate. Earnings Power Value is defined as the company’s sustainable earnings divided by the company’s cost of capital. There are of course a few assumptions made about these inputs but nothing as wild as in the case of DCFs.
The great advantage of this technique is that it does not muddy the valuation process with future predictions. It evaluates a company based on its current and historical situation alone. However, that is also a potential a weakness in that it may systematically undervalue growth companies. Value Investors might regard this as being part of the margin of safety but in normal markets, it may even be difficult to find a company that’s selling for less than its EPV! This highly conservative approach is a very useful tool in the Value Investors armoury.
What would Buffett do?
As we have discovered, finding the intrinsic value of a stock is a very tricky art but that doesn’t mean that you should refrain from doing it and just lean on the P/E ratio. Relative Valuations as we have seen lead investors to lose confidence in their ability to weather stock market storms. If you are absolutely certain that a company can generate a steady flow of cash in the future, you can have great confidence that the true value for that company lies within a certain range. That confidence becomes a mast to which the investor can tie his decisions when the waters become choppy. Certainty in decision making is the goal.
This kind of great confidence allows someone like Warren Buffett to step into tough markets like we witnessed in 2002 and 2009 and make extremely bold investments when all those around him were selling. It is this absolute confidence in his understanding of the intrinsic value of the sustainable cashflow of companies such as Goldman Sachs or American Express that allows him know when he is getting a bargain. This is something that all investors need to learn from.