Earnings are not equivalent to cash flows

These metrics rely  on reported profits or earnings rather than cash flows:

P/E

P/EBITDA

P/S

P/BV

EV/EBITDA

Profits may not reflect the actual underlying cash flows.

Some examples:

1.  Interest paid on perpetual securities (perps)  

• These are not considered interest expense, thereby inflating profits.  
• At the same time, accounting for perps as equity also understates the company's actual gearing.

2.  Companies can capitalise interest expense as assets in certain circumstances

• Interests during construction of assets or when property developers borrow to purchase land for future development.  
• This would understate expenses and inflate profits and book value.

3.  Companies can be in total compliance with financial reporting standards but still be misleading

• A company is allowed to recognise construction revenue from in-house concessionaires based on estimated fair values of future income streams under the long-term agreements.  This revenue is recorded as financial receivables/intangible assets on the balance sheet.  
• When the concession asset commences operation, cash flows generated from the asset are recognised as sales, while the operating costs include amortisation of the financial receivables/intangible assets.  
• Basically, companies report earnings even when there is no cash flow during the construction period, and then actual cash flows are higher than reported earnings when the asset is in operation.  
• In short, reported earnings have little relationship to the actual cash flows.

It is far easier to manipulate profits than cash flows, unless the bank statements are also falsified.

Management faked sales invoices or "pre-billings" 

• This is to inflate sales, Ebitda, profits and book values -  to give the impression that the company was worth more than it really was.  
• As such, scrutinising the Cash Flow Statement - which shows the sources and applications of cash, tying the cash balance at the start and end of the financial period - can be more informative than the popular Profit and Loss Statement.

Ignoring the risk of debt

Also, most of these metrics often measure earnings against market capitalisation. 

• For instance, the P/E ratio attributes value to the earnings - but ignores the risks of debt used to generate those earnings.  
• This omission can have serious consequences for investors.
• A company with debts may appear to have more attractive valuations but this come with higher risks, which are not immediately evident and therefore, not properly accounted for, simply by looking at the Profit & Loss statement.  
• When companies have to borrow to service debts, the situation will, often spiral rapidly out of control.

Ref:  Tong's Portfolio 2  It's all a matter of trust

Where do you always want to start a valuation?

STARTING A VALUATION 

Asset Valuation 

Where do you always want to start a valuation?  You want to start with assets.  Why?  Because they are tangible.  You could technically go out and look at everything that is on the firm’s balance sheet. Even the intangibles like the product portfolio you could investigate it today without making any projections or extrapolations.  You could even investigate the quality of things like the trained labor force and the quality of their business relationships with their customers (I think this is very difficult to ascertain). 

Start with that. It is also your most reliable information. It is also all that is going to be there if this is not a viable industry, because if this is not a viable industry, this company is going to get liquidated.  And what you are going to see is the valuation in liquidation. And that is very closely tied to the assets.   In that case, with that strategic assumption, you are going to go down that balance sheet and see what is recoverable.  But suppose the industry is viable, suppose it is not going to die. How do you value the assets then? Well, if the industry is viable then sooner or later the assets are going to be replaced so you have to look at the cost of reproducing those assets as efficiently as possible.   So what you are going to do is you are going to look at the reproduction value of the assets in a case where it is a viable industry.  And that is where you are going to start. We will go in a second and a little more tomorrow about the mechanics of doing that reproduction asset valuation. But that is value that you know is there.  


Earnings Power Valuation

The second thing you are going to look at because it is the second most reliable information you are going to look at is the current earnings. Just the earnings that you see today or that are reasonably forecastable as the average sustainable earnings represented by the company as it stands there today.   

And then we are going to extrapolate.  We are going to say suppose there was no growth and no change what would the value of those earnings be? Let’s not get into the unreliable elements of growth. Let’s look secondly at the earnings that are there and see what value there is. And that is the second number you are going to calculate and the likely market value of this company.  But it turns out that those two numbers are going to tell you a lot about the strategic reality and the likely market value of this company.  

Illustration

Suppose this is a commodity business like Allied Chemical and you have looked at the cost of reproducing the assets.  And you think you have done a pretty good job at that—And you could build or add buildings, plants, cash, accounts receivables and inventory that represents this business-- customer relationships, a product line--for a billion dollars.  This is usually going to be the cost for their most efficient competitors, who are the other chemical companies.  So the cost of reproducing this company is a billion dollars. Suppose on the other hand its earnings power is $200 million, and its cost of capital is 10% so the value of it s earnings which mimics its market value is two billion dollars ($200 million/0.10).  What is going to happen in that case?  Is that  two billion $ going to be sustainable?   $2 billion in earnings power value (EPV) is double the asset value (AV) of the company but there are no sustainable competitive advantages. If EPV is > than AV, then sustainability depends upon franchise value (“FV”). 

Well, think about what is going on in the executive suites of all these chemical companies. They are going to seed projects where they can invest $1 billion dollars and create two billion dollars of value.  What these guys love better than their families are chemical plants.  So you know those chemical plants are going to get built if there is not something to prevent that process of entry.


Introduction to a Value Investing Process by Bruce Greenblatt at the Value Investing Class Columbia Business School 
Edited by John Chew at Aldridge56@aol.com                           
studying/teaching/investing Page 24 


Additional notes:

Reversion to the Mean or the Uniformity of One Price 

As the chemical plants get built, what is going to happen to this chemical price?  It is going to go down. The margins will decline, the earnings power value and the market value of the company will go down. Suppose it goes down to a $1.5 billion.  Will that stop the process of entry?  No, not at all. Because the opportunity will still be there.  (Profits still above the cost of capital) 

In theory, the process of entry should stop when the cost of reproducing those assets equal the market value of those assets.  In practice, of course, it is easier to buy a puppy than to drown it later.  Once those puppies are bought, you are stuck with it.  The process of exit is slower than entry.   The same thing applies to chemical plants.  Once those chemical plants are built, they are likely to stay there for a long time.  Typically, the process may not stop there.  It applies equally to differentiated products. Suppose Ford, to reproduce their assets of the Lincoln division is $5 billion and the earnings power value and the market value is 8 billion. What is going to happen then?  Mercedes, the Europeans and the Japanese are going to look at that opportunity, and they are going to enter. 

Now do prices necessarily fall?  No, not in this case, they match Ford’s price. What will happen to Ford’s sales?  Inevitably they are going to go down because they will lose sales to the entrants.  What therefore will happen to their unit fixed costs?  The costs will rise.  Their variable costs are not going down, so their unit costs are going up.  The prices are staying the same, their margins are going down and their per units sold and their sales are going down, so what happens to profits here with a differentiated market and with a differentiated product?  Exactly the same thing.  

The differentiated products won’t save you. And that will go on until the profit opportunity disappears.  Unless there is something to interfere with this process of entry, sooner or later the market value of the company will be driven down to the reproduction value of the assets.  Especially, in the case of the Internet. You had companies that didn’t have any earnings that were $5, $10 or $15 billion dollars whose assets could be reproduced for $10 million or $15 million dollars.  Unless there is something to stop the process of entry, the earnings to support that are not going to materialize.  So what you are looking at is a decline.

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