Three useful yardsticks of business value

 Business Valuation 

To be a value investor, you must buy at a discount from underlying value. 

Analyzing each potential value investment opportunity therefore begins with an assessment of business value. 

While a great many methods of business valuation exist, there are only three that I find useful. 

1.  NPV

The first is an analysis of going-concern value, known as net present value (NPV) analysis. NPV is the discounted value of all future cash flows that a business is expected to generate. 

[Using multiples.  A frequently used but flawed shortcut method of valuing a going concern is known as private-market value. This is an investor’s assessment of the price that a sophisticated businessperson would be willing to pay for a business. Investors using this shortcut, in effect, value businesses using the multiples paid when comparable businesses were previously bought and sold in their entirety. ]

2.  Liquidation value

The second method of business valuation analyzes liquidation value, the expected proceeds if a company were to be dismantled and the assets sold off. Breakup value, one variant of liquidation analysis, considers each of the components of a business at its highest valuation, whether as part of a going concern or not. 

3.  Stock market value

The third method of valuation, stock market value, is an estimate of the price at which a company, or its subsidiaries considered separately, would trade in the stock market. Less reliable than the other two, this method is only occasionally useful as a yardstick of value. 

Conclusions:

Each of these methods of valuation has strengths and weaknesses. 

None of them provides accurate values all the time. 

Unfortunately no better methods of valuation exist. 

Investors have no choice but to consider the values generated by each of them; when they appreciably diverge, investors should generally err on the side of conservatism.

Be patient. Patience is sometimes the hardest part of using the value approach.

The patient exercise of value investing principles works and works well.

Value investing requires more effort than brains, and a lot of patience.

Over time, investors should continue to be rewarded for buying stocks on the cheap.

Through the years, there have been changes in the methods of finding value stocks and in the criteria that define value.



Changes in the method of finding value stocks and trading

In Ben Graham's time, the search for undervalued stocks meant poring through the Moody's and Standard & Poor's tomes for stocks that fit the value criteria.  Now, you can accomplish this with the click of a mouse.  You can access almost all the data off your Bloomberg terminals.  The 10k reports or annual shareholder letters are all right there on the Internet for you to access for stocks all over the world.

Trading has changed as well.  For the most part, trading is now done electronically with no effort at all.  You can trade stocks in New York, Tokyo or London just as easily as you can in your own country.


Criteria that define value has changed over time

Just as the access to information and the methods of trading stocks have changed in the past two decades, so have the criteria for value changed.


1.  Net current assets
In 1969, the investors were looking through the Standard & Poor's monthly stock guide for stocks selling below net current assets.  This was the primary source of cheap stocks in those days.  The method had been pioneered by Graham and was very successful.  Generally, they were buying stocks that sold for less than their liquidation value.  Back then, manufacturing companies dominated the US economy.


2.  Earnings
As the US economy grew in the 1960s, 1970s, and 1980s, it began to move away from the heavy industrial manufacturing companies such as steel and textiles.  Consumer product companies n service companies became more a part of the landscape.   These companies needed less physical assets to produce profits, and their tangible book values were less meaningful as a measure of value.  Many value investors had to adopt and began to look more closely at earnings--based models of valuation.  Radio and television stations and newspapers were examples of businesses that could generate enormous earnings with little in the way of physical assets and thus had fairly low tangible book value.  The ability to learn new ways to look at value allows you to make some profitable investments that you might well have overlooked had you not adopted wit the times.


3.  Earnings growth 
There was a great deal of money to be made buying companies that could grow their earnings at a faster rate than the old industrial type companies.  Warren Buffett said that growth and value are joined at the hip.  The difference between growth and value was mostly a question of price.  Paying a little more than just buying stocks based on book value and the investors found great bargains like American Express, Johnson & Johnson, and Capital Cities Broadcasting.  Companies like these were able, and in many cases still are able, to grow at rates significantly greater than the economy overall and were worth a higher multiple of earnings than a basic manufacturing business..


4.  Leveraged buyout business
In the mid-1980s, the leveraged buyout business (LBO) was born.  The US economy was emerging from a period of high inflation and high interest rates.  Inflation had increased the value of the assets of many companies.  For example, if ABC Ice Cream had built a new factory 5 years ago for $10 million and was depreciating it over  10 year period, it would have been written down to $5 million on ABC's books.  However, after  years of inflation, it might cost $15 million to replace that factory.  Its value is understated on the company's books.  Using the factory as collateral, the company might have been able to borrow 60% of its current value or $9 million.  This is what LBO firms did with all sorts of assets in the 1980s.  They would borrow against  company's assets to finance the purchase of the company.

The record high interest rates of the late 1970s and early 1980s drove stock prices to their lowest levels in decades.  The price-to-earnings ratio of the Standard & Poor's 500 was in the single digits.  With long-term Treasury bonds yielding 14%, who needed to own stocks?  The combination of significant undervalued collateral and low PE ratios made many companies ripe for acquisition at very low prices.  

A typical deal in the mid-1980s might be done at only 4.5 or 5 times pretax earnings.  Today, that number is more in the range of 9 to 12 times pretax earnings.  This period was a once-in-a-lifetime opportunity to buy companies at record cheap prices in terms of both assets and earnings.

By using this model to screen for companies that are selling in the stock market at a significant discount to what an LBO group might pay, this  LBO model gave one more way of defining "cheap"


{Summary:  Price to Book Value, Price to Earnings and Leveraged Buyout Appraisal Value]




Value Investing

The basic idea of buying stocks for less than they are worth and selling them as they approach their true worth is at the heart of value investing.

The methods and criteria have changed over the years and they will evolve further with the march of time and inevitable change.  What is important is that the principles have not changed.

On balance, value investing is easier than other forms of investing.  It is not necessary to spend eight hours a day glued to a screen trading frenetically in and out of stocks.  By paying attention to the basic principle of buying below intrinsic value with a margin of safety and exercising patience, investors will find that the value approach continues to offer investors the best way to beat the stock market indexes and increase wealth over time.



Patience is sometimes the hardest part of using the value approach 

When you find a stock that sells for 50% of what you determined it is worth , your job is basically done.  Now it is up to the stock. 

• It may move up toward its real worth today, next week, or next year.  
• It may trade sideways for 5 years and then quadruple in price.  
• There is simply no way to know when a particular stock will appreciate, or if, in fact, it will.   

There will be periods when the value approach will under-perform other strategies, and that can be frustrating.

Perhaps even more frustrating are those times when the overall market has risen to such high levels that we are unable to find many stocks that meet our criterion for sound investing.

It is sometimes tempting to give in and perhaps relax one criterion just a bit, or chase down some for the hot money stocks that seem to go up forever.  But, just about the time that value investors throw in the towel and begin to chase performance is when the hot stocks get ice cold.

Business value cannot be precisely determined. Make use of ranges of values.

Business value cannot be precisely determined. 

Not only do a number of assumptions go into a business valuation, but relevant macro and micro economic factors are constantly changing, making a precise valuation impossible. 

Although anyone with a calculator or a spreadsheet can calculate a net present value of future cash flows, the precise values calculated are only as accurate as the underlying assumptions.

Investors should instead make use of ranges of values, and in some cases, of applying a base value. 

Ben Graham wrote:

The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is adequate—e.g., to pro­tect a bond or to justify a stock purchase—or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.

There are only three ways to value a business. 

1.   The first method involves finding the net present value by discounting future cash flows. 

Problems with this method involve trying to predict future cash flows, and determining a discount rate. 

Investors should err on the side of conservatism in making assumptions for use in net present value calculations, and even then a margin of safety should be applied.

2.  The second method is Private Market Value using Multiples. 

This is a multiples approach (e.g. P/E, EV/Sales) based on what business people have paid to acquire whole companies of a similar nature. 

The problems with this method are that comparables assume businesses are all equal, which they are not. 

Furthermore, exuberance can cause business people to make silly decisions. 

Therefore, basing your price on a price based on irrationality can lead to disaster. 

This is believed to be the least useful of the three valuation methods.

3.  Finally, liquidation value as a method of valuation. 

A distinction must be made between a company undergoing a fire sale (i.e. it needs to liquidate immediately to pay debts) and one that can liquidate over time. 

Fixed assets can be difficult to value, as some thought must be given to how customised the assets are (e.g. downtown real-estate is easily sold, mining equipment may not be).

When should each method be employed? 

They can all be used simultaneously to triangulate towards a value. 

In some cases, however, one might place more confidence in one method over the others. 

For example, 

• liquidation value would be more useful for a company with losses that trades below book value, while 
• net present value is more useful for a company with stable cash flows.

Using the methods of valuation described, you can search for stocks that are trading at a severe discount; it is possible, their stock price more than doubled soon after.

Beware of these failures

The failures of relying on a company's earnings per share - too easily massaged.

The failure of relying on a company's book value  - not necessarily relevant to today's value.

The failure of relying on a company's dividend yield - incentives of management to make yields appear attractive at the expense of the company's future.

Read also:

• 
  
• Your investments using Mutual Funds or Money Managers
• Trading and portfolio management from a value investing point of view
• Value Investor's Opportunities in Distressed Securities
• Value Investing Opportunities in the Banking Sector
• Look at FUNDAMENTALS and POTENTIAL CATALYSTS when making investment decisions
• Where to look for Investment Opportunities
• Business value cannot be precisely determined. Make use of ranges of values
• Central elements to a Value Investing Philosophy
• The Philosophy of Value Investing and Why It Works
• Philosophy of value investing. Need to have clear strategies too
• How Wall Streets can create investment fads? The Junk Bond Market of mid-1980s
• Understanding these changes in the investment world allows investors to earn superior returns
• What's good for Wall Street is not necessarily good for investors
• Speculators, Investors and Market Fluctuations

Valuation methods

Even the best investing strategies won't help you if you don't understand the value of the investments you are making.

Without assessing the future potential of your investments, you are simply gambling by letting probability take over.

It is in the nature of investment valuation that the calculations of their value are mathematical.


Return on Investment (ROI)

This is the end result of how much money you make or lose on an investment.

ROI = (P - C) / C

P= current market price at which you sold the investment
C = cost of the investment - the price you paid for it.


Present Value

Present value is the value that an investment with known future value has at the present time.

PV = FV / [(1+r)^t]

FV= amount of money you will receive at the end of the investment's life
r= the rate of return you are earning on the investment during that time
t= the amount of time that passes (in years) between now and the end of the investment's life.

This is an extremely common calculation with bonds, since bonds are sold at the discounted rate (the present value), and you must estimate whether the market price of the bond is above or below the present value to determine whether the price is worth it.


Net Present Value (NPV)

Net present value is the sum of present values on an investment that generates multiple cash flows.

When calculating NPV, calculate the present values of each payment you will receive, and then add them together.



ABSOLUTE AND RELATIVE MODELS

The value of fixed-rate investments is easy because you have certainty regarding what you will earn.

The problems come when you start estimating the value of variable-rate investments, like stocks or derivatives.

There are many complicated methods of calculating variable-rate investments, but they fall into three categories:

Absolute
Relative, and
Hybrid


Absolute models

Liquidation value or intrinsic value

Absolute models are the most popular among investors who look for the intrinsic value of an investment, rather than attempting to benefit by trading on movements in the market.

Such models include calculations of the liquidation value of the company, often adjusted for growth over the next few years.

In other words, you start with what the company would be worth if you simply sold everything it has for the cash, then subtract the debt.

Of course, the value of companies changes over time, and the market price of stocks is often based on the future earning potential of the company, rather than its current earnings.

So, estimates of liquidation value start with the current liquidation value and then increase that value by a percentage consistent with their average past growth, or by some other estimate of their future growth.


Dividend Discount Model  (DDM)

For investors who prefer investments that yield dividends, the DDM is popular.

DDM is calculated by working out the NPV of future dividends.

If you estimate that dividends will grow over that period, simply subtract the growth rate from the rate of return in the NPV calculation.

NPV = Dividend / (R - g)

R= discount rate
g= growth rate

For dividend investors, if the NPV of the dividends is lower than the current market price per share of the stock, the stock is undervalued, making it a great deal.


Relative Models

Relative models are popular among traders, who invest based on short-term movements in the market because they allow them to compare the performance of various options.

Common tools in performing these comparative assessments use the financial statements of a company and include:

Price to earnings ratio (P/E)

This functions as an indicator of the price you are paying for the profits a company will earn for you, either as dividends or through the investment of retained earnings.

Return on equity (ROE) = Net Income / Shareholder Equity

This indicates the amount of money a company makes using the money shareholders have invested in the company.

Operating margin = Operating Income / Net Sales

This indicates how efficiently a company is operating.


These indicators are not calculations of company value, but indicators of the comparative performance of companies in which one might invest.



Hybrids

Absolute and relative models are combined to create hybrids that attempt to estimate the value of a stock by combining the intrinsic value of the company with how well it performs compared to other potential investments.