How Much Research and Analysis Are Sufficient?

Some investors insist on trying to obtain perfect knowledge about their impending investments, researching companies until they think they know everything there is to know about them. They study the industry and the competition, contact former employees, industry consultants, and analysts, and become personally acquainted with top management. They analyze financial statements for the past decade and stock price trends for even longer.

This diligence is admirable, but it has two shortcomings. 

• First, no matter how much research is performed, some information always remains elusive; investors have to learn to live with less than complete information. 
• Second, even if an investor could know all the facts about an investment, he or she would not necessarily profit. 

This is not to say that fundamental analysis is not useful. It certainly is.

• But information generally follows the well-known 80/20 rule: the first 80 percent of the available information is gathered in the first 20 percent of the time spent. 
• The value of in-depth fundamental analysis is subject to diminishing marginal returns. 
• Information is not always easy to obtain. Some companies actually impede its flow. Understandably, proprietary information must be kept confidential. 
• The requirement that all investors be kept on an equal footing is another reason for the limited dissemination of information; information limited to a privileged few might be construed as inside information. Restrictions on the dissemination of information can complicate investors' quest for knowledge nevertheless. 

Moreover, business information is highly perishable. 

• Economic conditions change, industries are transformed, and business results are volatile. 
• The effort to acquire current, let alone complete information is never-ending. 
• Meanwhile, other market participants are also gathering and updating information, thereby diminishing any investor's informational advantage. 

David Dreman recounts the story of an analyst so knowledgeable about Clorox that he could recite bleach shares by brand in every small town in the Southwest and tell you the production levels of Clorox's line number 2, plant number 3. But somehow, when the company began to develop massive problems, he missed the signs....' The stock fell from a high of 53 to 11." 

Although many Wall Street analysts have excellent insight into industries and individual companies, the results of investors who follow their recommendations may be less than stellar. 

• In part this is due to the pressure placed on these analysts to recommend frequently rather than wisely, but it also exemplifies the difficulty of translating information into profits. 
• Industry analysts are not well positioned to evaluate the stocks they follow in the context of competing investment alternatives. 
• Merrill Lynch's pharmaceutical analyst may know everything there is to know about Merck and Pfizer, but he or she knows virtually nothing about General Motors, Treasury bond yields, and Jones & Laughlin Steel first-mortgage bonds. 

Most investors strive fruitlessly for certainty and precision, avoiding situations in which information is difficult to obtain.

• Yet high uncertainty is frequently accompanied by low prices. 
• By the time the uncertainty is resolved, prices are likely to have risen. 
• Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. 
• The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.

Value Investing and Contrarian Thinking

Value investing by its very nature is contrarian. 

Out-of-favor securities may be undervalued; popular securities almost never are. 


What the herd is buying is, by definition, in favor.

• Securities in favor have already been bid up in price on the basis of optimistic expectations and are unlikely to represent good value that has been overlooked. 

If value is not likely to exist in what the herd is buying, where may it exist?

• In what they are selling, unaware of, or ignoring. 
• When the herd is selling a security, the market price may fall well beyond reason. 
• Ignored, obscure, or newly created securities may similarly be or become undervalued. 

Investors may find it difficult to act as contrarians for they can never be certain whether or when they will be proven correct. 

• Since they are acting against the crowd, contrarians are almost always initially wrong and likely for a time to suffer paper losses. 
• By contrast, members of the herd are nearly always right for a period. 
• Not only are contrarians initially wrong, they may be wrong more often and for longer periods than others because market trends can continue long past any limits warranted by underlying value. 

Holding a contrary opinion is not always useful to investors, however.

• When widely held opinions have no influence on the issue at hand, nothing is gained by swimming against the tide. 
• It is always the consensus that the sun will rise tomorrow, but this view does not influence the outcome. 

By contrast, when majority opinion does affect the outcome or the odds, contrary opinion can be put to use. 

• When the herd rushes into home health-care stocks, bidding up prices and thereby lowering available returns, the majority has altered the risk/reward ratio, allowing contrarians to bet against the crowd with the odds skewed in their favor. 
• When investors in 1983 either ignored or panned the stock of Nabisco, causing it to trade at a discount to other food companies, the risk/reward ratio became more favorable, creating a buying opportunity for contrarians.

Market Inefficiencies and Institutional Constraints

The research task does not end with the discovery of an apparent bargain. It is incumbent on investors to try to find out why the bargain has become available. 

If in 1990 you were looking for an ordinary, four-bedroom colonial home on a quarter acre in the Boston suburbs, you should have been prepared to pay at least $300,000. If you learned of one available for $150,000, your first reaction would not have been, "What a great bargain!" but, "What's wrong with it?" The same healthy skepticism applies to the stock market. A bargain should be inspected and reinspected for possible flaws. 


Irrational or indifferent selling alone may have made it cheap, but there may be more fundamental reasons for the depressed price.

• Perhaps there are contingent liabilities or pending litigation that you are unaware of. 
• Maybe a competitor is preparing to introduce a superior product. 
• When the reason for the undervaluation can be clearly identified, it becomes an even better investment because the outcome is more predictable. 

By way of example, the legal constraint that prevents some institutional investors from purchasing low priced spinoffs is one possible explanation for undervaluation. Such reasons give investors some comfort that the price is not depressed for an undisclosed fundamental business reason.

Other institutional constraints can also create opportunities for value investors.  For example, many institutional investors . become major sellers of securities involved in risk-arbitrage transactions on the grounds that their mission is to invest in ongoing businesses, not speculate on takeovers. The resultant selling pressure can depress prices, increasing the returns available to arbitrage investors.

Institutional investors are commonly unwilling to buy or hold low-priced securities. Since any company can exercise a degree of control over its share price through splitting or reverse-splitting its outstanding shares, the financial rationale for this constraint is hard to understand. Why would a company's shares be a good buy at $15 a share but not at $3 after a five-for-one stock split or vice versa?

Many attractive investment opportunities result from market inefficiencies, that is, areas of the security markets in which information is not fully disseminated or in which supply and demand are temporarily out of balance. Almost no one on Wall Street, for example, follows, let alone recommends, small companies whose shares are closely held and infrequently traded; there are at most a handful of market makers in such stocks. Depending on the number of shareholders, such companies may not even be required by the SEC to file quarterly or annual reports. Obscurity and a very thin market can cause stocks to sell at depressed levels. 

Year-end tax selling also creates market inefficiencies. The Internal Revenue Code makes it attractive for investors to realize capital losses before the end of each year.  Selling driven by the calendar rather than by investment fundamentals frequently causes stocks that declined significantly during the year to decline still further. This generates opportunities for value investors.

Where to look for opportunities: The Challenge of Finding Attractive Investments

Investment Research: The Challenge of Finding Attractive Investments 

While knowing how to value businesses is essential for investment success, the first and perhaps most important step in the investment process is knowing where to look for opportunities. 

Investors are in the business of processing information, but while studying the current financial statements of the thousands of publicly held companies, the monthly, weekly, and even daily research reports of hundreds of Wall Street analysts, and the market behavior of scores of stocks and bonds, they will spend virtually all their time reviewing fairly priced securities that are of no special interest.


Good investment ideas are rare and valuable things, which must be ferreted out assiduously.

• They do not fly in over the transom or materialize out of thin air. 
• Investors cannot assume that good ideas will come effortlessly from scanning the recommendations of Wall Street analysts, no matter how highly regarded, or from punching up computers, no matter how cleverly programmed, although both can sometimes indicate interesting places to hunt. 

Upon occasion attractive opportunities are so numerous that the only limiting factor is the availability of funds to invest; typically the number of attractive opportunities is much more limited.

• By identifying where the most attractive opportunities are likely to arise before starting one's quest for the exciting handful of specific investments, investors can spare themselves an often fruitless survey of the humdrum majority of available investments. 

Value investing encompasses a number of specialized investment niches that can be divided into three categories:

• securities selling at a discount to breakup or liquidation value, 
• rate-of-return situations, and 
• asset-conversion opportunities. 

Where to look for opportunities varies from one of these categories to the next.

• Computer-screening techniques, for example, can be helpful in identifying stocks of the first category: those selling at a discount from liquidation value. Because databases can be out of date or inaccurate, however, it is essential that investors verify that the computer output is correct. 
• Risk arbitrage and complex securities comprise a second category of attractive value investments with known exit prices and approximate time frames, which, taken together, enable investors to calculate expected rates of return at the time the investments are made. Mergers, tender offers, and other risk-arbitrage transactions are widely reported in the daily financial press-the Wall Street Journal and the business section of the New York Times-as well as in specialized newsletters and periodicals. Locating information on complex securities is more difficult, but as they often come into existence as byproducts of risk arbitrage transactions, investors who follow the latter may become aware of the former. 
• Financially distressed and bankrupt securities, corporate recapitalizations, and exchange offers all fall into the category of asset conversions, in which investors' existing holdings are exchanged for one or more new securities. Distressed and bankrupt businesses are often identified in the financial press; specialized publications and research services also provide  information on such companies and their securities. Fundamental information on troubled companies can be gleaned from published financial statements and in the case of bankruptcies, from court documents. Price quotations may only be available from dealers since many of these securities are not listed on any exchange. Corporate recapitalizations and exchange offers can usually be identified from a close reading of the daily financial press. Publicly available filings with the Securities and Exchange Commission (SEC) provide extensive detail on these extraordinary corporate transactions. 

Many undervalued securities do not fall into any of these specialized categories and are best identified through old-fashioned hard work, yet there are widely available means of improving the likelihood of finding mispriced securities.

• Looking at stocks on the Wall Street Journal's leading percentage-decline and new-low lists, for example, occasionally turns up an out-of-favor investment idea. 
• Similarly, when a company eliminates its dividend, its shares often fall to unduly depressed levels. 
• Of course, all companies of requisite size produce annual and quarterly reports, which they will send upon request. Filings of a company's annual and quarterly financial statements on Forms 10K and 10Q, respectively, are available from the SEC and often from the reporting company as well. 
• Sometimes an attractive investment niche emerges in which numerous opportunities develop over time. One such area has been the large number of thrift institutions that have converted from mutual to stock ownership. Investors should consider analyzing all companies within such a category in order to identify those that are undervalued. Specialized newsletters and industry periodicals can be excellent sources of information on such niche opportunities.

The Choice of a Discount Rate

The other component of present-value analysis, choosing a discount rate, is rarely given sufficient consideration by investors.

• A discount rate is, in effect, the rate of interest that would make an investor indifferent between present and future dollars. 
• Investors with a strong preference for present over future consumption or with a preference for the certainty of the present to the uncertainty of the future would use a high rate for discounting their investments. 
• Other investors may be more willing to take a chance on forecasts holding true; they would apply a low discount rate, one that makes future cash flows nearly as valuable as today's. 
• There is no single correct discount rate for a set of future cash flows and no precise way to choose one. 

The appropriate discount rate for a particular investment depends not only on an investor's preference for present over future consumption but also on his or her own risk profile, on the perceived risk of the investment under consideration, and on the returns available from alternative investments.

• Investors tend to oversimplify; the way they choose a discount rate is a good example of this. 
• A great many investors routinely use 10 percent as an all-purpose discount rate regardless of the nature of the investment under consideration. 
• Ten percent is a nice round number, easy to remember and apply, but it is not always a good choice. 
• The underlying risk of an investment's future cash flows must be considered in choosing the appropriate discount rate for that investment. 
• A short-term, risk-free investment (if one exists) should be discounted at the yield available on short-term U.S. Treasury securities, which, as stated earlier, are considered a proxy for the risk-free interest rate.
• Low-grade bonds, by contrast, are discounted by the market at rates of 12 to 15 percent or more, reflecting investors' uncertainty that the contractual cash flows will be paid. 

It is essential that investors choose discount rates as conservatively as they forecast future cash flows.

• Depending on the timing and magnitude of the cash flows, even modest differences in the discount rate can have a considerable impact on the present-value calculation. 
• Business value is influenced by changes in discount rates and therefore by fluctuations in interest rates. 
• While it would be easier to determine the value of investments if interest rates and thus discount rates were constant, investors must accept the fact that they do fluctuate and take what action they can to minimize the effect of interest rate fluctuations on their portfolios. 

How can investors know the "correct" level of interest rates in choosing a discount rate?

• I believe there is no "correct" level of rates. 
• They are what the market says they are, and no one can predict where they are headed. 
• Mostly I give current, risk-free interest rates the benefit of the doubt and assume that they are correct. 
• Like many other financial-market phenomena there is some cyclicality to interest rate fluctuations. 
• High interest rates lead to changes in the economy that are precursors to lower interest rates and vice versa. 
• Knowing this does not help one make particularly accurate forecasts, however, for it is almost impossible to envision the economic cycle until after the fact. 

At Times when Interest Rates are Unusually Low

• At times when interest rates are unusually low, however, investors are likely to find very high multiples being applied to share prices. 
• Investors who pay these high multiples are dependent on interest rates remaining low, but no one can be certain that they will. 
• This means that when interest rates are unusually low, investors should be particularly reluctant to commit capital to long-term holdings unless outstanding opportunities become available, with a preference for either holding cash or investing in short-term holdings that quickly return cash for possible redeployment when available returns are more attractive. 

Investors can apply present-value analysis in one of two ways.

• They can calculate the present-value of a business and use it to place a value on its securities. 
• Alternatively, they can calculate the present-value of the cash flows that security holders will receive: interest and principal payments in the case of bondholders and dividends and estimated future share prices in the case of stockholders. 
• Calculating the present value of contractual interest and principal payments is the best way to value a bond. 
• Analysis of the underlying business can then help to establish the probability that those cash flows will be received. 

By contrast, analyzing the cash flows of the underlying business is the best way to value a stock.

• The only cash flows that investors typically receive from a stock are dividends. 
• The dividend-discount method of valuation, which calculates the present value of a projected stream of future dividend payments, is not a useful tool for valuing equities; for most stocks, dividends constitute only a small fraction of total corporate cash flow and must be projected at least several decades into the future to give a meaningful approximation of business value. 
• Accurately predicting that far ahead is an impossibility. 
• Once future cash flows are forecast conservatively and an appropriate discount rate is chosen, present value can be calculated. 

In theory, investors might assign different probabilities to numerous cash flow scenarios, then calculate the expected value of an investment, multiplying the probability of each scenario by its respective present value and then summing these numbers.

• In practice, given the extreme difficulty of assigning probabilities to numerous forecasts, investors make do with only a few likely scenarios. 
• They must then perform sensitivity analysis in which they evaluate the effect of different cash flow forecasts and different discount rates on present value. 
• If modest changes in assumptions cause a substantial change in net present value, investors would be prudent to exercise caution in employing this method of valuation.

Present-Value Analysis and the Difficulty of Forecasting Future Cash Flow

When future cash flows' are reasonably predictable and an appropriate discount rate can be chosen, NPV analysis is one of the most accurate and precise methods of valuation.

Unfortunately future cash flows are usually uncertain, often highly so.

Moreover, the choice of a discount rate can be somewhat arbitrary. 

These factors together typically make present value analysis an imprecise and difficult task.



The Perfect Business to Value - Annuity

A perfect business in terms of the simplicity of valuation would be an annuity; an annuity generates an annual stream of cash that either remains constant or grows at a steady rate every year. 



Real businesses, even the best ones, are unfortunately not annuities. 

Few businesses occupy impenetrable market niches and generate consistently high returns, and most are subject to intense competition. 

Small changes in either revenues or expenses cause far greater percentage changes in profits. 

The number of things that can go wrong greatly exceeds the number that can go right.

Responding to business uncertainty is the job of corporate management.

However, controlling or preventing uncertainty is generally beyond management's ability and should not be expected by investors.'

How do value investors deal with the analytical necessity to predict the unpredictable?

The only answer is conservatism. 

Since all projections are subject to error, optimistic ones tend to place investors on a precarious limb.

Virtually everything must go right, or losses may be sustained.

Conservative forecasts can be more easily met or even exceeded. 

Investors are well advised to make only conservative projections and then invest only at a substantial discount from the valuations derived therefrom.

Three elements of a value-investment strategy: Bottom-up approach, Absolute performance orientation, and Managing risk.

The primary goal of value investors is to avoid losing money. 

Three elements of a value-investment strategy make achievement of that goal possible.

1.   A bottom-up approach, searching for low-risk bargains one at a time through fundamental analysis, is the surest way I know to avoid losing money.

2.  An absolute performance orientation is consistent with loss avoidance; a relative-performance orientation is not.

3.  Finally, paying careful attention to risk - the probability and amount of loss due to permanent value impairments - will help investors avoid losing money.



So long as generating portfolio cash inflow is not inconsistent with earning acceptable returns, investors can reduce the opportunity cost resulting from interim price declines even as they achieve their long-term investment goals.

Managing Portfolio Cash Flow. Cash is the most Important determinant of Opportunity Cost

Most important determinant of opportunity cost:  Cash portion of your portfolio

If you hold cash, you are able to take advantage of opportunities during market declines.

If you are fully invested when the market declines, your portfolio will likely drop in value, depriving you of the benefits arising from the opportunity to buy in at lower levels.

This creates an opportunity cost, the necessity to forego future opportunities that arise.

If what you hold is illiquid or unmarketable, the opportunity cost increases further; the illiquidity precludes your switching to better bargains.

The most important determinant of whether investors will incur opportunity cost is whether or not part of their portfolios is held in cash.

Maintaining moderate cash balances or owning securities that periodically throw off appreciable cash is likely to reduce the number of foregone opportunities.



Managing portfolio cash flow

Investors can manage portfolio cash flow (defined as the cash flowing into a portfolio minus outflows) by giving preference to some kinds of investments over others.

Portfolio cash flow is greater for securities of shorter duration (weighted average life) than those of longer duration.

Portfolio cash flow is also enhanced by investments with catalysts for the partial or complete realization of underlying value.

Equity investments in ongoing businesses typically throw off only minimal cash through the payment of dividends.

The securities of companies in bankruptcy and liquidation, by contrast, can return considerable liquidity to a portfolio within a few years of purchase.

Risk-arbitrage investments typically have very short lives, usually turning back into cash, liquid securities, or both in a matter of weeks or months.

An added attraction of investing in risk-arbitrage situations, bankruptcies, and liquidations is that not only is one's initial investment returned to cash, one's profits are as well.



Hedging

Another way to limit opportunity cost is through hedging.

A hedge is an investment that is expected to move in a direction opposite that of another holding so as to cushion any price decline.

If the hedge becomes valuable, it can be sold, providing funds to take advantage of newly created opportunities. 

The Relevance of Temporary Price Fluctuations (unrelated to Underlying Value)

Permanent loss versus Interim Price Fluctuations

In addition to the probability of permanent loss attached to an investment, there is also the possibility of interim price fluctuations that are unrelated to underlying value. (Beta fails to distinguish between the two.)

Many investors consider price fluctuations to be a significant risk: if the price goes down, the investment is seen as risky regardless of the fundamentals.



But are temporary price fluctuations really a risk? 

Not in the way that permanent value impairments are and then only for certain investors in specific situations. 

It is, of course, not always easy for investors to distinguish temporary price volatility, related to the short-term forces of supply and demand, from price movements related to business fundamentals. The reality may only become apparent after the fact.

While investors should obviously try to avoid overpaying for investments or buying into businesses that subsequently decline in value due to deteriorating results, it is not possible to avoid random short-term market volatility. 

Indeed, investors should expect prices to fluctuate and should not invest in securities if they cannot tolerate some volatility. 




If you are buying sound value at a discount, do short-term price fluctuations matter? 

In the long run they do not matter much; value will ultimately be reflected in the price of a security.

Indeed, ironically, the long-term investment implication of price fluctuations is in the opposite direction from the near-term market impact. 

For example, short-term price declines actually enhance the returns of long-term investors.' 



Near-term price fluctuations matter to certain investors

There are, however, several eventualities in which near-term price fluctuations do matter to investors.

1.   Security holders who need to sell in a hurry are at the mercy of market prices.

• The trick of successful investors is to sell when they want to, not when they have to.
• Investors who may need to sell should not own marketable securities other than U.S. Treasury bills.

2.   Near-term security prices also matter to investors in a troubled company. 

• If a business must raise additional capital in the near term to survive, investors in its securities may have their fate determined, at least in part, by the prevailing market price of the company's stock and bonds. (This effect, known as reflexivity.)

3.  Volatility is the friend of the long term value investor.

• The third reason long-term-oriented investors are interested in short-term price fluctuations is that Mr. Market can create very attractive opportunities to buy and sell. 

Conventional Valuation Yardsticks: Dividend Yield

Dividend Yield

Why is my discussion of dividend yield so short?

• Although at one time a measure of a business's prosperity, it has become a relic: stocks should simply not be bought on the basis of their dividend yield. 

Too often struggling companies sport high dividend yields, not because the dividends have been increased, but because the share prices have fallen. 

• Fearing that the stock price will drop further if the dividend is cut, managements maintain the payout, weakening the company even more. 
• Investors buying such stocks for their ostensibly high yields may not be receiving good value.  On the contrary, they may be the victims of a pathetic manipulation. 
• The high dividend paid by such companies is not a return on invested capital but rather a return of capital that represents the liquidation of the underlying business. 
• This manipulation was widely used by money-center banks through most of the 1980s and had the (desired) effect of propping up their share prices.

Conventional Valuation Yardsticks: Earnings, Book Value, and Dividend Yield
Both earnings and book value have a place in securities analysis but must be used with caution and as part of a more comprehensive valuation effort.

Conventional Valuation Yardsticks: Book Value

Book Value

What something cost in the past is not necessarily a good measure of its value today.  Book value is the historical accounting of shareholders' equity, the residual after liabilities are subtracted from assets.

Sometimes historical book value (carrying value) provides an accurate measure of current value, but often it is way off the mark.

• Current assets, such as receivables and inventories, for example, are usually worth close to carrying value, although certain types of inventory are subject to rapid obsolescence. 
• Plant and equipment, however, may be outmoded or obsolete and therefore worth considerably less than carrying value. 
• Alternatively, a company with fully depreciated plant and equipment or a history of write-offs may have carrying value considerably below real economic value. 
• Inflation, technological change, and regulation, among other factors, can affect the value of assets in ways that historical cost accounting cannot capture. 
• Real estate purchased decades ago, for example, and carried on a company's books at historical cost may be worth considerably more. 
• The cost of building a new oil refinery today may be made prohibitively expensive by environmental legislation, endowing older facilities with a scarcity value. 
• Aging integrated steel facilities, by contrast, may be technologically outmoded compared with newly built mini-mills. As a result, their book value may be significantly overstated. 

Reported book value can also be affected by management actions.

• Write-offs of money-losing operations are somewhat arbitrary yet can have a large impact on reported book value. 
• Share issuance and repurchases can also affect book value. 
• Many companies in the 1980s, for example, performed recapitalizations, whereby money was borrowed and distributed to shareholders as an extraordinary dividend. This served to greatly reduce the book value of these companies, sometimes below zero. 
• Even the choice of accounting method for mergers-purchase or pooling of interests - can affect reported book value.

To be useful, an analytical tool must be consistent in its valuations. Yet, as a result of accounting rules and discretionary management actions, two companies with identical tangible assets and liabilities could have very different reported book values.

• This renders book value not terribly useful as a valuation yardstick. 

As with earnings, book value provides limited information to investors and should only be considered as one component of a more thorough and complete analysis.

Conventional Valuation Yardsticks: Earnings, Book Value, and Dividend Yield

Both earnings and book value have a place in securities analysis but must be used with caution and as part of a more comprehensive valuation effort.

Conventional Valuation Yardsticks: Earnings and Earnings Growth

Earnings and Earnings Growth

Earnings per share has historically been the valuation yardstick most commonly used by investors.

Unfortunately, as we shall see, it is an imprecise measure, subject to manipulation and accounting vagaries.

It does not attempt to measure the cash generated or used by a business.

And as with any prediction of the future, earnings are nearly impossible to forecast.


Massaging earnings by managements

Corporate managements are generally aware that many investors focus on growth in reported earnings, and a number of them gently massage reported earnings to create a consistent upward trend.

A few particularly unscrupulous managements play accounting games to turn

• deteriorating results into improving ones, 
• losses into profits, and 
• small profits into large ones.

Earnings can mislead as to the real profit.

Even without manipulation, analysis of reported earnings can mislead investors as to the real profitability of a business.

Generally accepted accounting practices (GAAP) may require actions that do not reflect business reality.

• By way of example, amortization of goodwill, a noncash charge required under GAAP, can artificially depress reported earnings; an analysis of cash flow would better capture the true economics of a business. 
• By contrast, nonrecurring gains can boost earnings to unsustainable levels, and should be ignored by investors." 

Most important, whether investors use earnings or cash flow in their valuation analysis, it is important to remember that the numbers are not an end in themselves. Rather they are a means to understanding what is really happening in a company.




Conventional Valuation Yardsticks: Earnings, Book Value, and Dividend Yield

Both earnings and book value have a place in securities analysis but must be used with caution and as part of a more comprehensive valuation effort.

Business valuation is a complex process yielding imprecise and uncertain results.

1.   Many businesses simply cannot be valued intelligently.

Many businesses are so diverse or difficult to understand that they simply cannot be valued.

Some investors willingly voyage into the unknown and buy into such businesses, impatient with the discipline required by value investing.


2.   Wait for the right pitch to swing

Investors must remember that they need not swing at every pitch to do well over time; indeed, selectivity undoubtedly improves an investor's results. 


3.   Stay within your Circle of Competence

For every business that cannot be valued, there are many others that can. 

Investors who confine themselves to what they know, as difficult as that may be, have a considerable advantage over everyone else.

Choosing Among Valuation Methods

How should investors choose among the several valuation methods? 

When is one clearly preferable to the others? 

When one method yields very different values from the others, which should be trusted?

At times, a particular method may stand out as the most appropriate. 



Valuation Methods

1.   Net Present Value, NPV
Net present value would be most applicable, for example, in valuing a high-return business with stable cash flows such as a consumer-products company; its liquidation value would be far too low.

Similarly, a business with regulated rates of return on assets such as a utility might best be valued using NPV analysis.


2.   Liquidation Value
Liquidation analysis is probably the most appropriate method for valuing an unprofitable business whose stock trades well below book value.  


3.   Stock Market Value
A closed-end fund or other company that owns only marketable securities should be valued by the stock market method; no other makes sense.


4.   Several methods to value a complex business
Often, several valuation methods should be employed simultaneously.  To value a complex entity such as a conglomerate operating several distinct businesses for example,  some portion of the assets might be best valued using one method and the rest with another. 


5.   Several methods to value a single business to obtain a range of values.
Frequently investors will want to use several methods to value a single business in order to obtain a range of values.  In this case, investors should err on the side of conservatism, adopting lower values over higher ones unless there is strong reason to do otherwise.  True, conservatism may cause investors to refrain from making some investments that in hindsight would have been successful, but it will also prevent some sizable losses that would ensue from adopting less conservative business valuations.

Avoidance of loss is the surest way to ensure a profitable outcome.

Be fearful when others are greedy

It can be hard to concentrate on potential losses

• while others are greedily reaching for gains and 
• your broker is on the phone offering shares in the latest "hot" initial public offering. 

Yet the avoidance of loss is the surest way to ensure a profitable outcome.




Stocks do outperform bonds and cash over the years

A loss-avoidance strategy is at odds with recent conventional market wisdom.  Today, many people believe that risk comes, not from owning stocks, but from not owning them.   

• Stocks as a group, this line of thinking goes, will outperform bonds or cash equivalents over time, just as they have in the past.
• Indexing is one manifestation of this view.  
• The tendency of most institutional investors to be fully invested at all times is another.

There is an element of truth to this notion; stocks do figure to outperform bonds and cash over the years. 



Equities are inherently riskier than debt instruments

Being junior in a company's capital structure and lacking contractual cash flows and maturity dates, equities are inherently riskier than debt instruments.

• In a corporate liquidation, for example, the equity only receives the residual after all liabilities are satisfied.  
• To persuade investors to venture into equities rather than safer debt instruments, they must be enticed by the prospect of higher returns.   
• However, the actual risk of a particular investment cannot be determined from historical data.  It depends on the price paid. 
• If enough investors believe the argument that equities will offer the best long-term returns, they may pour money into stocks, bidding prices up to levels at which they no longer offer the superior returns.  
• The risk of loss stemming from equity's place in the capital structure is exacerbated by paying a higher price.

Risk avoidance is the single most important element of an investment program

Another common belief is that risk avoidance is incompatible with investment success. This view holds that high return is attainable only by incurring high risk and that long-term investment success is attainable only by seeking out and bearing, rather than avoiding, risk.

Why do I believe, conversely, that risk avoidance is the single most important element of an investment program?

• If you had $1,000, would you be willing to wager it, double or nothing, on a fair coin toss?  Probably not.
• Would you risk your entire net worth on such a gamble?  Of course not.
• Would you risk the loss of, say, 30% of your net worth for an equivalent gain"  Not many people would because the loss of a substantial amount of money could impair their standard of living while a comparable gain might not improve it commensurately. 

Conclusion:

If you are one of the vast majority of investors who are risk averse, then loss avoidance must be the cornerstone of your investment philosophy.

"Don't lose money." Avoiding loss should be the primary goal of every investor.

Warren Buffett likes to say that the first rule of investing is "Don't lose money," and the second rule is, "Never forget the first rule."

Avoiding loss should be the primary goal of every investor.

This does not mean that investors should never incur the risk of any loss at all.

Rather "don't lose money" means that over several years an investment portfolio should not be exposed to appreciable loss of principal.


Avoidance of loss is the surest way to ensure a profitable outcome.

Why should the history of the junk-bond market in the 1980s interest investors today?

The junk-bonds market collapsed in 1990.

• Junk bonds were transformed into the financial equivalent of roach motels; investors could get in , but they couldn't get out.  
• Bullish assumptions were replaced by bearish ones.  
• Investor focus shifted from what might go right to what could go wrong, and prices plummeted.

Why should the history of the junk-bond market in the 1980s interest investors today?

If you personally avoided investing in newly issued junk bonds, what difference should it make to you if other investors lost money?

The answer is that junk bonds had a pernicious effect on other sectors of the financial markets and on the behaviour of most financial-market participants.

• The overpricing of junk bonds allowed many takeovers to take place at inflated valuations.
• The excess profits enjoyed by the shareholders of the acquired companies were about equal to the losses eventually experienced by the buyers of this junk.
• Cash received by equity investors from junk-bond-financed acquisitions returned to the stock market, bidding up the prices of shares in still independent companies. 
• The market prices of securities involved in arbitrage transactions, exchange offers, and corporate reorganizations were all influenced by the excessive valuations made possible by the junk-bond market.  
• As a result, even those who avoided owning junk bonds found it difficult to escape their influence completely.

We may confidently expect that there will be new investment fads in the future.  

• They too will expand beyond the rational limitations of the innovation. 
• As surely as this will happen, it is equally certain that no bells will toll to announce the excess.  
• Investors who study the junk-bond debacle may be able to identify these new fads for what they are and avoid them.  
• And avoiding losses is the most important prerequisite to investment success.

EBITDA Analysis Obscures the Difference between Good and Bad Businesses

EBITDA, in addition to being a flawed measure of cash flow, also masks the relative importance of the several components of corporate cash flow.

Pretax earnings and depreciation allowance comprise a company's pretax cash flow; earnings are the return on the capital invested in a business, while depreciation is essentially a return of the capital invested in a business.


Service Company X
(millions)
Revenue $100
Cash Expenses  80
Depreciation and Amortization 0
___________________________
EBIT  $20
___________________________
EBITDA $20



Manufacturing Company Y
(millions)
Revenue $100
Cash Expenses  80
Depreciation and Amortization 20
____________________________
EBIT  $0
____________________________
EBITDA $20



Investors relying on EBITDA as their only analytical tool would value these two businesses equally.

At equal prices, however, most investors would prefer to own Company X, which earns $20 million, rather than Company Y, which earns nothing.

Although these businesses have identical EBITDA, they are clearly not equally valuable. 

• Company X could be a service business that owns no depreciable assets.   
• Company Y could be a manufacturing business in a competitive industry.

Company Y must be prepared to reinvest its depreciation allowance (or possibly more, due to inflation) in order to replace its worn-out machinery.   It has no free cash flow over time.

• Anyone who purchased Company Y on a leveraged basis would be in trouble.  
• To the extent that any of the annual $20 million in EBITDA were used to pay cash interest expense, there would be a shortage of funds for capital spending when the plant and equipment needed to be replaced. 
• Company Y would eventually go bankrupt, unable both to service its debt and maintain its business.  

Company X, by contrast, has no capital-spending requirements and thus has substantial cumulative free cash flow over time.

• Company X, by contrast, might be an attractive buyout candidate.

The shift of investor focus from after-tax earnings to EBIT and then to EBITDA masked important differences between businesses, leading to losses for many investors.

EBITDA: analytically flawed and resulted in the chronic overvaluation of businesses

Investors in public companies have historically evaluated them on reported earnings.

By contrast, private buyers of entire companies have valued them on free cash flow.



Historical

In the latter half of the 1980s, entire businesses were bought and sold almost as readily as securities, and it was not unreasonable for investors in securities to start thinking more like buyers and sellers of entire businesses.

In a radical departure from the historical norm, many stock and junk-bond buyers in the latter half of the 1980s replaced earnings with cash flow as the analytical measure of value.

In their haste to analyze free cash flow, investors in the 1980s sought a simple calculation, a single number, that would quantify a company's cash-generating ability.  The cash-flow calculation the great majority of investors settled upon was EBITDA.

Virtually all analyses of highly leveraged firms relied on EBITDA as a principal determinant of value, sometimes as the only determinant.  

Even non-leveraged firms came to be analysed in this way since virtually every company in the late 1980s was deemed a potential takeover candidate.  

Unfortunately EBITDA was analytically flawed and resulted in the chronic overvaluation of businesses.





How should cash flow be measured?

Before the junk-bond era investors looked at two components: 

• after tax earnings, (that is the profit of a business); plus 
• depreciation and amortization minus capital expenditures (that is, the net investment or disinvestment in the fixed assets of a business.)

The availability of large amounts of non-recourse financing changed things.  

Since interest expense is tax deductible, pretax, not after-tax, earnings are available to pay interest on debt; money that would have gone to pay taxes goes instead to lenders. 

A highly leveraged company thus has more available cash flow than the same business utilizing less leverage.


Notwithstanding, EBIT is not necessarily all freely available cash.

• If interest expense consumes all of EBIT, no income taxes are owed.
• If interest expense is low, however, taxes consume an appreciable portion of EBIT.

At the height of the junk-bond boom, companies could borrow an amount so great that all of EBIT (or more than all of EBIT) was frequently required for paying interest.  

In a less frothy lending environment companies cannot become so highly leveraged at will. 

• EBIT is therefore not a reasonable approximation of cash flow for them.  
• After-tax income plus that portion of EBIT going to pay interest expense is a company's true cash flow derived from the ongoing income stream.

Depreciation

Cash flow, also results from the excess of depreciation and amortization expenses over capital expenditures.  It is important to understand why this is so. 

• When a company buys a machine, it is required under GAAP to expense that machine over its useful life, a procedure known in accounting as depreciation.  
• Depreciation is a noncash expense that reduces net reported profits but not cash.  
• Depreciation allowances contribute to cash but must eventually be used to fund capital expenditures that are necessary to replace worn out plant and equipment.  
• Capital expenditures are thus a direct offset to depreciation allowances; the former is as certain a use of cash as the latter is a source.  

The timing may differ: a company may invest heavily in plant and equipment at one point and afterward generate depreciation allowances well in excess of current capital spending. 

• Whenever the plant and equipment need to be replaced, however cash must be available.  
• If capital spending is less than depreciation over a long period of time, a company is undergoing gradual liquidation.

Amortization

Amortization of goodwill is also a noncash charge but,conversely, is more of an accounting fiction than a real business expense. 

When a company is purchased for more than its tangible book value, accounting rules require the buyer to create an intangible balance-sheet asset known as goodwill to make up for the difference, and then to amortize that goodwill over forty years. 

• Amortization of goodwill is thus a charge that does not necessarily reflect a real decline in economic value and that likely need not be spent in the future to preserve the business. 
• Charges for goodwill amortization usually do represent free cash flow.

Why was EBITDA used?

It is not clear why investors suddenly came to accept EBITDA as a measure of corporate cash flow. 

• EBIT did not accurately measure the cash flow from a company's ongoing income stream.  
• Adding back 100% of depreciation and amortization to arrive at EBITDA rendered it even less meaningful.  

Those who used EBITDA as a cash-flow proxy, for example, either ignored capital expenditures or assumed that businesses would not make any, perhaps believing that plant and equipment do not wear out.  

• In fact, many leveraged takeovers of the 1980s forecast steadily rising cash flows resulting partly from anticipate sharp reductions in capital expenditures.  
• Yet the reality is that if adequate capital expenditures are not made, a corporation is extremely unlikely to enjoy a steadily increasing cash flow and will instead almost certainly face declining results.

What is the required level of capital expenditure for a given business?

It is not easy to determine the required level of capital expenditures for a given business.  Businesses invest in physical plant and equipment for many reasons: 

• to remain in business, 
• to compete, 
• to grow and 
• to diversify.  

Expenditures to stay in business and to compete are absolutely necessary. 

Capital expenditures required for growth are important but not usually essential.

Capital expenditures made for diversification are often not necessary at all.  

Identifying the necessary expenditures requires intimate knowledge of a company, information typically available only to insiders.  

Since detailed capital-spending information are not readily available to investors, perhaps they simply chose to disregard it.

EBITDA by ignoring capital expenditures is flawed

Some analysts and investors adopted the view that it was not necessary to subtract capital expenditures from EBITDA because ALL the capital expenditures of a business could be financed externally (through lease financing, equipment trusts, nonrecourse debt, etc.). 

• One hundred percent of EBITDA would thus be free pretax cash flow available to service debt; no money would be required for reinvestment int he business.  

This view was flawed, of course. 

• Leasehold improvements and parts of a machine are not typically financeable for any company.  
• Companies experiencing financial distress, moreover, will have limited access to external financing for any purpose.   
• An over-leveraged company that has spent its depreciation allowances on debt service may be unable to replace worn-out plant and equipment and eventually be forced into bankruptcy or liquidation.

EBITDA:  a clear case of circular reasoning to justify high takeover prices

EBITDA may have been used as a valuation tool because no other valuation method could have justified the high takeover prices prevalent at the time. 

This would be a clear case of circular reasoning. 

• Without high-priced takeovers there we no upfront investment banking fees, no underwriting fees on new junk-bond issues, and no management fees on junk-bond portfolios.  
• This would not be the first time on Wall Street that the means we adapted to justify an end.  
• If a historically accepted investment yardstick proves to be overly restrictive, the path of least resistance is to invent a new standard.