Relative versus Absolute Valuation

Dear New Investor,

Take Andy Warhol’s “200 One Dollar Bills” silkscreen for example. This piece of art, which probably cost right around $200 to create sold for a staggering £26 million in late 2009. How can that price be justified?

To start, you could attribute much of the value to the Warhol name. Then you’d probably consider the meaning to the buyer, the piece’s importance relative to other works, and what someone else might pay for it down the road.

Using that same thought process, how would you justify the price tag of, say, £3, £4 or £5 for any particular share? There are many paths to the mountaintop, but all valuation techniques attempt to answer this question.

At Share Advisor, whether we’re looking at an income producing share or the next great growth story, we don’t want to overpay for a share. Not only does this reduce potential future gains – it increases our chances of losing money. That’s why any time we put money into a company’s shares, valuation will be a key part of the process.

Relative vs. Absolute

There are two major schools of thought when it comes to the valuation of shares:

1. Relative valuation: This is by far the most common type of valuation method in the market, for reasons I’ll discuss in a moment. With relative valuation methods, you’re comparing one company’s metrics (price-to-earnings, price-to-book, etc.) versus another company or the industry at large. For example, if there are two equally good companies, but one trades for ten-times earnings and the other for fifteen-times earnings, you would conclude that the company that trades for ten-times earnings is relatively undervalued.
2. Absolute valuation: The point of absolute valuation methods like the dividend discount (DDM) and discounted cash flow (DCF) models is to determine the “intrinsic” or fair value of a company, regardless of how its metrics stack up against competitors at a given time.

While the Share Advisor team may employ some relative valuation methods in our analysis, we’ll largely rely on absolute valuation to make our buy and sell decisions.

The Case For and Against Relative Valuation

According to Aswath Damodaran, a professor at New York University’s Stern School of Business, relative valuation is “pervasive”. He reckons that:

		Almost 85% of equity research reports are based on valuation multiples and comparables.
		More than 50% of all acquisition valuations are based on multiples.
		Rules of thumb based on multiples are not only common but are also often the basis for final valuation judgments.

If this doesn’t scare you, it should.

Why?

Because if most shares are trading at 30 times earnings, relative valuation could make a share trading at 25 times earnings appear undervalued and therefore worth buying.

But if it turns out that all shares are overpriced and should be trading at just 15 times earnings, you might lose money along with everyone else when the market declines. Your share wasn’t undervalued at all.

Despite its flaws, it’s easy to see why relative valuation is prevalent among City traders. Using relative numbers, analysts can always find undervalued shares (ever wonder why analysts can rate so many shares a buy?), and portfolio managers can always justify being fully invested at all times.

Because money managers make their bread by having assets under management, Warren Buffett aside, you won’t find many of them saying, “I can’t find anything to buy, so it’s time to cash out.”

Finally, when your own performance is judged relative to other analysts and portfolio managers, it’s much safer to ride with the herd and make relative valuations. After all, you only need to be marginally better than your peers to become a star. On the other hand, if you deviate from the herd and are proven wrong, you’re often wrong alone and your time as an analyst will likely be short-lived.

To borrow a lesson from childhood, remember that what’s right is not always popular, and what’s popular is not always right.

Sticking to Fundamentals

The inherent volatility spawned by this irrational behaviour creates opportunities for business-focused investors with longer time horizons.

At Share Advisor, we stick to the business fundamentals – think profits and cash flows – to estimate a share’s intrinsic value. By taking this approach though, we implicitly assume three things:

1.		That the market can be irrational in the short term.
2.		That we have something the market doesn’t have.
3.		That the market will eventually correct itself.

I think many people would agree on the first point that the market can be irrational. As for the second point, the individual investor’s greatest advantage over the market is our ability to be patient and remain focused on an investment’s underlying business, regardless of the market’s happy days or temper tantrums.

This type of patience is uncommon. The average holding period for a FTSE share is just7 months, according to a September 2010 speech given by Andy Haldane of The Bank of England. That’s down from eight years in the 1960s.

That’s not investing; that’s trading.

When we buy a share at Share Advisor, we plan to own it for at least three years, or as long as the valuation and business make it worth owning. In fact, the longer our time horizon, the better our chances should be of being proven correct – by giving the market more time to revert to what we regard as the company’s proper value (and meanwhile, a growing, fundamentally strong company should continue to add value).

So as long as we can stay patient, we should have a distinct advantage over other investors.

This leads us to our third point, which is the biggest assumption because it requires a catalyst that’s beyond our control. Whether it’s a positive earnings report, a change in management, or an unexpected event, an undervalued stock can’t reach its fair value without something knocking some sense back into the market.

Admittedly, the longer we need to wait for the market to recognize a company’s fair value, the more trying it becomes to hold onto the position, especially if the share continues to underperform. To resist our human tendencies to follow the herd, we deliberately review our businesses’ fundamentals to determine whether we should keep holding our shares.

Using Share Advisor Valuations

In all of our Share Advisor buy reports, we give you our estimate of the fair value for the company and a preferred price at which to buy the share (though if you can get in lower, that’s generally better). The numbers are our best estimates at the time – so they’re not set in stone. Sometimes following good results our forecast will improve later, and we’ll tell you when that happens, whilst other times it will decline.

There’s no such thing as a precise valuation. Every estimate of fair value is just that – an estimate which attempts to weigh the probabilities of various good and bad scenarios that could befall a company and its shares. Measuring probability accurately is pretty tricky and sticking too tightly to an estimate of value runs the risk of creating a false sense of precision. I would be wary of any analyst that provides you a value estimate down to the pence for a share – it is just unreasonable to expect that level of accuracy from any valuation method.

The uncertainty around our estimates of value is one of the reasons we require a meaningful margin of safety (usually around 20%) from our estimated fair value before recommending a share.

Our preferred buy price isn’t the be-all and end-all either. If a share is trading just above our preferred buy price, that shouldn’t stop you from buying it if you want to – remember, we’re giving you our best estimate of fair value and estimates are fuzzy, so applying overly strict buy limits creates another opportunity for false precision.

By taking a long-term, business-focused approach to valuing shares, we should have a distinct advantage in an irrational market. Over time, we expect it will help us build a diverse portfolio that generates superior income as well as winning returns.

Motley Fool