My mother-in-law is known to my kids as Doodles. The name’s origin is a long story, but what’s important here is that she is extremely smart and a very capable businesswoman (she doesn’t go by “Doodles” professionally). Despite her business expertise, she is always asking me questions about the stock market that seem to miss the underlying philosophy behind long-term value investing.
In an effort to not seem like an evasive jerk, I will attempt to explain once and for all what I actually do.
(For the record, Doodles is just a proxy for every social acquaintance who has ever asked me a question about the stock market. If I am addressing a dumb statement, assume that it was an insane distant relative who inspired my commentary. If the question is nuanced and complicated, assume it was the work of Doodles.)
OK, Doodles, you’ve done your screen for decent investment candidates ('Quality' Requires More Than a Story
) and you have the right mind-set about margin of safety (Forget What You Know About Margin of Safety
). Now, how are you going to value this awesome investment?
Unfortunately, there are probably a thousand different ways to come up with an estimate of what your beloved stock is worth (including astrology). The thing to keep in mind is that no matter which methodology you use, you will be wrong. That’s right, wrong. Unless you and Doc Brown have some timeshare arrangement with the DeLorean, you are not going to be able to tell the future. Like it or not, we are going to have to use human judgment at some point. Let’s try to see to it that we put that judgment in a place where it can give us the most analytical flexibility.
Valuation gets confusing because many folks value businesses with tools that are better used for uncovering clues that value may be present, rather than as a means for determining an “answer” to the valuation question. Many of these tools determine valuation as a multiple of something or other. All of them present valuation in a nice package that makes it easy to chat with other investors about the stock (which, admittedly, can be useful). They have all sorts of rules of thumb attached to them based on years of investor practice. But that simplicity and convenience can leave serious blind spots if you carry it through your thinking about the business’s valuation.
Here’s an incomplete list of common “valuation” methods and why I don’t like them:
This is the first one everybody learns. It can be a good lens when screening companies for “value” candidates. But let’s say we have determined that Caterpillar’s
(NYSE:CAT) earnings for 2013 will be $8.00. Is 11x that number a fair price, or would 13x be more appropriate? As we try to determine what our stock is worth (i.e. determining a forward P/E multiple), keep these factors in mind: What is the revenue growth rate (beyond 2013) that’s baked into that multiple? How about margin expansion or contraction after 2013? Where does “13x” address the capital spending required over the next couple of years? How does the company’s level of debt or cash on the balance sheet figure into the picture?
Honestly, you might as well be throwing a dart.
Enterprise Value/ EBITDA (EV/EBITDA)
Again, OK for screening. This one avoids some of the problems with P/E, but just barely. It still only covers one year’s snapshotted results and still doesn’t account for varying levels of capital expenditure. It does include debt levels into the calculation, but isn’t super-transparent about how a change in the multiple translates into an effect on the equity (which is the part we stockholders own). What’s the difference between 10x EBITDA and 11x EBITDA to the shares of United Technologies
(NYSE:UTX)? Hint: it’s not 10%, because they have net debt.
Price/Book Value (P/B)
For financials, this might be useful for screening. For non-financials, maybe this one makes sense if you intend to liquidate the company. It can be a sign that there is value lurking on the balance sheet (“If the business is a bust, then at the very least we can sell it for scrap.”). But it doesn’t really say much, prospectively, about what an ongoing business should be worth. The actual profits generated by the business aren’t even in the formula (except as scraps that make their way onto the balance sheet, piled on top of prior years’ gains and losses). How would I decide whether PepsiCo
(NYSE:PEP) is worth 5x BV or 6x BV? Is the fact that Tangible Book is a negative number going to melt my spreadsheet?
You are killing it if you bought dart futures a couple of bullet points ago.
Any Calculation That Relies on Historical Trading Ranges or Another Asset’s Price Level
Historical stock trading ranges have nothing to do with analyzing the future of the underlying business. There is nothing to say that past trading was “correct” or that past business conditions are analogous to future prospects. As for dragging another asset into the picture, I saw this mentioned in a research note the other day. An analyst suggested that his or her price target for the stock was going up (in part) because the firm’s estimate for the S&P 500
(INDEXSP:INX) went from X to Y. Nothing. To. Do. With. The. Business. We. Are. Analyzing.
After reading this, I was ready to heroically step in front of the darts.
Go With the (Discounted Cash) Flow (DCF)
There are so many undelineated assumptions in these previous valuation methodologies that it is hard to justify any of them beyond shrugging our shoulders and mumbling something about a “rule of thumb.” Personally, I prefer to be honest with myself about my assumptions. If I am going to go into this valuation thing knowing that I will be wrong, at least I am going to spell out my assumptions so that I can create much richer (wrong) scenarios and get a range
of plausible values for the stock. Then I can judge whether or not there is enough of a cushion (margin of safety).
Giving a full-blown DCF example is beyond the scope of our little chat. But the basic idea of a DCF is that we are going to account for the cash that comes in the door and the cash that goes out the door for the next several years. We won’t give full credit for each dollar, because a dollar today is worth more than a dollar sometime in the future. If you don’t believe that, I will be happy to give you $1 million, 30 years from now, in exchange for you giving me $1 million today. Just send the check to my home address.
We need to forecast several years of after-tax profits (which means declaring assumptions for revenues and margins); expected changes in working capital (which means making assumptions on the efficiency of the day-to-day business operations); and capital expenditures for longer-term assets (we can also add back cash flow for any asset sales we expect). We will want to forecast quite a few years’ worth of results, to cover the time period we expect the business’s competitive advantage to remain valid. Then we will need to make some assumptions about what the business will be worth in that post-competitive-advantage future.
We will determine a discount rate based on the firm’s cost of capital (the explicit cost of its debt and the implicit cost of its equity – each weighted in proportion to how it is used to finance the business. This is a messy number that we could argue about for days. For now, let’s be content that we can use a range of assumptions.) We discount each year’s cash flows and add ‘em up. This gives us a forecast for Enterprise Value. Subtract the debt on the balance sheet and add back the excess cash and you’ve got yourself an expectation for what the equity is worth!
Whew! (OK, there’s more “art” to it, but those are the basics. To really geek out on some of the pitfalls, check out Michael Mauboussin’s Common Errors in DCF Models
The real power here is not in coming up with a single, precise number. It is in being able to play with your forecasts to see how sensitive your valuation is to specific variables. How reasonable are your base-case assumptions? What if things went really
right or really
wrong? How off would you need to be in order for the stock to still
be fairly valued at its current levels? Importantly, we are thinking hard about the underlying business
. We’re starting to get a handle on just how much of a margin of safety is present. We are also walking into our ownership of this stock with our eyes wide open, with our assumptions spelled out explicitly.
Unfortunately, it is going to be cumbersome to discuss all of these assumptions with other folks when the talk at a party turns to stocks, but didn’t we already establish that you should be talking about your awesome grandkids