“Price is what you pay, Value is what you get.” Warren Buffett
Valuation is both art and science. Valuation is not an objective exercise; and any assumptions and biases that an analyst brings to the process will find its way into the value, which is why intrinsic value is often subjective. In other words, what is value to me might not be the same for you. This is why you’ll get differing results when 2 analysts value a company.
Price to earnings ratio is one of the most popular valuation metrics used among investors. When deciding whether or not to invest in a stock, investors often refer to its P/E ratio to determine if the stock is ‘cheap’. A low P/E stock suggest that the stock is undervalued while a high P/E stock is overvalued. But does that really work?
Not, if you’re using it wrongly. Allow me to explain this…
Investors assign value based on varying factors such as quality of the business, growth prospects, industry landscape, market share and predictability of earnings.
A company creates value when excess profits on capital invested outweighs its cost of capital. Therefore, companies with different ROIC and growth rates should have different values. Hence, comparing P/E ratios without considering these factors will lead to false conclusions.
For example, two companies that operates in different industries will be valued differently. A company in the healthcare sector tends to command a higher valuation than a company in consumer goods and services. The difference in valuation can be due to factors such as economic cycles, industry trends and risk sentiments. Given the different business models and industry between the two companies, it is wrong to assume that one is undervalued to another.
Second factor to note is, quality companies command a higher value than its competitors. Companies with moats are more valuable than companies without moats. Therefore, investors are willing to pay a premium for market leaders that are consistently gaining market share due to a vastly superior product. These companies are also more profitable and have better potential for growth than its competitors. Hence, high-quality companies rarely trade at discount to its peers.
Companies with recurring components in earnings will also command higher valuation as investors are willing to pay a premium for stability and predictability of earnings. Recurring revenue streams also serve as a buffer for income fluctuations. As a result, these businesses are less risky and present more opportunities for growth.
Take Adobe for example, from 2007 to 2012, its business stagnated. Sales stopped growing, and its stock price was stagnant from 2000 to 2012.
Like most other software companies, Adobe sold its computer programs on physical CDs. But in 2012, it made a change. The company decided to stop selling one-off products and began selling subscriptions to its computer programs. Instead of selling CDs, ADBE today charges customers $30 a month to access its programs on the cloud. Adobe Systems, soared 830% after switching to a subscription model.
How To Use Price to Earnings Ratio The Right Way
Step 1: Calculate PE with adjusted earnings ( subtract one-off earnings).
Step 2: Compare historical PE against current. Determine the average PE ratio over the past 5 years and use it as a benchmark. PE ratios that are 2 standard deviations away from its average can be considered overvalued or undervalued.
Step 3: Find a list of its competitors and compare its efficiency and profitability ratios with the company. This way you can compare target company with its peers. If something looks too cheap, you need to answer why the market has not recognized it yet. Often more than not, these stocks are cheap for a reason.
Choosing The Right Valuation Method For Stocks
For new investors, valuing a business can be a bewildering task.
There are 2 conventional approaches to valuation. The first, discounted cash-flow valuation, measures the value of a business to the present value of expected future cash-flows. The second, relative valuation, estimates the value of a stock by looking at the pricing of ‘comparable’ assets relative to a common variable such as earnings, cash-flows, book value or sales.
Let me illustrate this in simple terms for you…
John bought a $1 million apartment and have paid $600k thus far, which means he still owes the bank $400k (let’s assume interest payments are included in this calculations for simplicity sake).
After years of savings, John accumulated $200k of cash at bank for emergency purpose and owns an investment portfolio worth $400k.
Now, his estimated net worth will be the sum these:
Net Worth = Cash at bank + investment portfolio + total amount paid for condo =
200k + 400k + 600k = $1.2 million.
This assets represents the liquid net worth that he can liquidate or collateralize for future use.
In the context of valuing a business, we can consider balance sheet items such as fixed assets and current assets – subtracting it off all liabilities. This difference is known as Net Asset Value.
Second method is value derive from potential earnings, using John again to illustrate, assume John earns $200k yearly and expects zero to little salary increments over the next 6 years.
If things remain the same, John expects to earn $1.2 million in total earned income over the next 6 years. These cash flows are yet to be earned, therefore, if John decides for a career switch, he should certainly consider his future earnings.
In this context, to value a company from its potential earnings. The ability of a business to grow its earnings year after year determines the valuation of the company. A company with high growth is very likely to generate more profits in future, hence investors are willing to pay more for such companies.
Analysts use a wide range of models to value assets in practice, ranging from the
simple to the sophisticated. I’d like to share some simple techniques to help you determine the value of a stock and how you can include it in your investment framework.
Examples: Net Current Asset Value, Net Working Capital Value and Price to Tangible Book Value, Negative Enterprise Value
- Net Current Asset Value = Current Assets – Total Liabilities – Minority Interest
- Net Working Capital Value = (Cash and Cash Equivalent + 0.75 * Receivables + 0.5 * Inventories) – Total Liabilities – Minority Interest
- Price to Tangible Book Value = ((Cash + Land/Building + Investment Properties + Short and Long-term Investments) – Total Liabilities – Minority Interest)/ Market Capitalization
- Enterprise Value = Market cap + Total Liabilities + Minority Interest – Total Cash and Cash Equivalents.
Types: Asset heavy in industries (Real Estate, Construction, Engineering, Manufacturing, etc)
Asset-Based valuation often focuses on the good assets of the business while putting less emphasis on earnings. Good assets are cash, cash equivalents, short and long-term investments, deposits, trade receivables, inventories, investment properties, land/building, strategic investments in other companies and subsidiaries.
The key to prudent Asset-based valuation is to estimate conservative value for its balance sheet items. For example, if a business manufactures CDs, I would aggressively discount its inventories in valuation simply because global demand for CDs is low and declining. Therefore if its inventories are worth $100 mil, I will mark down its value by a minimum of 50%. This is to simulate a fire-sale if ever the business needs to be liquidated. Other assets in the balance sheet should be given appropriate discounts according to the nature of the business.
Discounted Cash Flow
Variations: Discounted Cash Flow on EBITDA, EBIT, Net Profit or Free Cash Flow.
Types: Mature companies with stable cash flows (Telco, Utilities, Public Transportation and Healthcare)
A Discounted Cash Flow model can be complex and subjective, assigning values for cash flows and discount rate are just assumptions of the future. However, the purpose of DCF analysis is to estimate the cash flow an investor receives on an investment adjusted for time value for money. DCF analysis can be a reliable tool for valuation if the inputs are estimated conservatively, however, a slight misjudgment of inputs can cause huge deviations in expected value.
Typically, a DCF consist of assumptions of the company’s weighted average cost of capital (WACC) and forecasting a terminal value. These inputs require a great deal of good judgement in not only the business but industry level knowledge and macro landscape.
Hence, the DCF can easily result in varying outputs among value investors and can provide a wide range of intrinsic values if assumptions are wrong. Personally, I prefer not to use DCF analysis but exceptions will be businesses with very PREDICTABLE cash flows and stable business environment.
Earnings Multiple Valuation
Variations: Price to Earnings, Enterprise Value to EBITDA/EBIT/Free Cash Flow, Price to Sales
Types: All Types
A method that is versatile, simple and reliable for valuation. This method allows investors to assess a business in a similar perspective of a private owner. Assume a business valued at EV/Free Cash flow of 5, if cash flows remain consistent over the past 5 years and conditions to remain stable going forward this suggests that an owner will receive 20% return annually.
Earnings multiples can also be compared to similar stocks within an industry, this can help you find undervalued gems in sectors. However, these metrics should not be used as a stand-alone. Investors must consider the nature of a business and consistency of its cash flows.
There are many ways to value a stock and there is so much information written about it. Typically, there are 2 main challenges when valuing a stock:
- Uncertainty and unpredictability
- Human errors and misjudgments
You can try to minimize these errors by creating a systematic process, using technology, documenting your reasons to make an investment decision, but you can never eliminate the nature of the stock market and human biases. There is a big school of study called “behavourial economics” that looks into this particular topic.
Valuation is an important part of an investment process, however, it is not the only part of the process. Valuation is an art, there’s no such thing as a one size fits all valuation tool. Customizing valuation methods for different businesses takes experience and qualitative ideas. It is just silly to value a stock blindly while ignoring business climate, quality of business and financial health of a business.