#Nothing is worth infinity.
We can
overpay for even the best of companies.
So even if we
understand a business (first step) and
find it to be good (second step) we can still make a
bad investment by paying too much.
The
third step in the value investing model asks a final fundamental question:
Is it inexpensive?
Inexpensiveness can be detected with
four different price metrics:
1. Times free cash flow (MCAP/FCF)
2. Enterprise value to operating income (EV/OI)
3. Price to book (MCAP/BV)
4. Price to tangible book value (MCAP/TBV)
#Price metrics
1. Times free cash flow.
It equals a company’s market capitalization divided by its levered free cash flow. It’s abbreviated
MCAP/FCF.
The denominator, levered free cash flow.
- It’s cash flow from operations minus capex.
- Note that it captures the payment of both interest and taxes.
The numerator, market capitalization, is often shortened to market cap.
- It’s the number of shares outstanding times the current price per share.
Notice the consistency between numerator and denominator.
- Market cap is the price for the equity only.
- Levered free cash flow is the cash thrown off by the business after debtholders have been paid their interest. Hence levered free cash flow goes to the equity holders.
Theoretically, market cap is what it would cost to buy all of a company’s outstanding shares.
- But it’s actually an underestimate.
- That’s because the current share price reflects only what some shareholders were—moments ago—willing to take for their stock.
- Most are holding out for more.
2. Enterprise value to operating income.
It’s abbreviated
EV/OI.
The
denominator, operating income.
- It’s revenue, minus cost of goods sold, minus operating expenses.
- Note that it’s not net of interest or tax expenses.
The numerator,
enterprise value, is the theoretical takeover price.
- It’s what one would fork over to buy the entire company, not just the outstanding shares.
- Paying it would leave no one else with any financial claim on the company.
- There’d be no outside common stockholders, no preferred shareholders, no minority partners in subsidiaries, no bondholders, no bank creditors, no one.
Enterprise value is a tricky concept, for
two reasons.
1.
First, it’s derived in part from current market prices.
- So in name, it defies the value investing distinction between price and value.
- The term enterprise price would make more sense.
2. Second, it’s harder to calculate.
- In essence, it equals market cap plus the market price of all of the company’s preferred equity, noncontrolling interest, and debt and minus cash.
Like market cap, the
enterprise value of a particular company is given on financial websites. Such off-the-shelf figures are convenient. But
if a company looks promising, it’s wise to calculate enterprise value longhand. To see why, consider its components.
3. Price to book.
It equals market cap divided by book value. It’s abbreviated
MCAP/BV.
Book value, recall, equals balance sheet equity.
4. Price to tangible book value, or MCAP/TBV.
It’s
MCAP/BV with
intangible assets removed from the denominator. Patents, trademarks, goodwill, and other assets that aren’t physical get subtracted.
MCAP/TBV is a harsher measure than MCAP/BV.
- It effectively marks any asset that can’t be touched down to zero.
- Some situations are better suited to this severity than others.
To see which ones, we revisit goodwill.
Recall that
goodwill equals acquisition price in excess of book value.
- We gave the example of company B having book value of $1,000,000; company A acquiring it for $1,500,000 in cash; and company A increasing the goodwill on its balance sheet by $500,000.
Note the assumption embedded in this practice.
- Goodwill is an asset.
- So in buying company B and goodwill, company A is swapping assets for assets. That’s how accounting sees it.
- No expense is recognized on the income statement, and no liability is booked on the balance sheet.
- Nothing bad occurs.
#What’s inexpensive, and what isn’t?
1. MCAP/FCF and EV/OI
When we calculate price metrics, we get actual numbers. MCAP/FCF may be 5, or 50. EV/OI may be 3, or 30.
What’s inexpensive, and what isn’t?
I like MCAP/FCF to be no higher than 8, and EV/OI to be no higher than 7.
Before moving on to benchmarks for the other two price metrics, let’s understand what these first two multiples mean.
- Imagine that a company’s future operating income will be $1,000,000 for each of the next 100 years. Discounting that stream back at—say—10 percent yields $9,999,274.
- That quantity, $9,999,274, is nearly $10 million. Notice that $10 million is 10 times the forecasted annual operating income.
- So if one calculates a company’s EV/OI as 10, that could mean that the market thinks operating earnings will be $1,000,000 for each of the next 100 years, and 10 percent is the right discount rate.
- Or, it could be mean that the market thinks operating income for the next 100 years will grow 4 percent annually from a $1,000,000 base, and that 14 percent is the right discount rate.
In other words, multiples are shorthand.
- They’re shorthand for a formal present value analysis.
- In them are embedded beliefs about growth rates and discount rates.
Holding everything else equal, it’s better to own a company with income that’s growing than one with income that isn’t.
So when I say that I want EV/OI to be no higher than 7, what I’m saying is that I’ll only buy a stream of future operating income when it’s offered to me at a high discount rate.
Of course one never knows just what future operating earnings will be. Same with free cash flow. And where the exact discount rates come from isn’t important.
What is important is this:
"low price multiples signal buying opportunities to the value investor when they reflect unjustifiably high discount rates."
2. MCAP/BV and MCAP/TBV
The other two price metrics,
MCAP/BV and MCAP/TBV, are a little different.
- They don’t reflect a stream of future anything.
- They’re multiples of what a company has now.
I prefer both MCAP/BV and MCAP/TBV to be no higher than 3.
But these are just qualifiers for me. They’re not what I look for.
What I look for is MCAP/FCF and EV/OI.
It’s worth exploring why.
#Why MCAP/FCF and EV/OI are preferred to MCAP/BV and MCAP/TBV?
I aim to
own companies that continue as going concerns.
- I want them alive.
- Profitable ones are worth more that way.
But
MCAP/BV and MCAP/TBV express price relative to the value of companies dead.
- If a firm stopped operating and sold everything—if it liquidated—the total amount available to distribute to shareholders would have something to do with its book value.
- But when I buy a stock, I don’t hope for a stake in some dead company’s yard sale. I’m buying a claim on future streams of income and cash flow.
This isn’t to say that
MCAP/BV and MCAP/TBV are useless. They can
uncover opportunities.
- Say that a company’s EV/OI is 9, and that both MCAP/BV and MCAP/TBV are 6.
- The company doesn’t look inexpensive.
- But MCAP/BV and MCAP/TBV are the same.
- This leads the astute investor to see if the company owns some juicy tangible asset like land that’s carried on the balance sheet at a tiny, decades-old purchase price.
- Will the company sell the land for cash?
- Will that cash be excess?
- If so, all of the price metrics could plunge. That’s the kind of useful thinking that the dead metrics tease out.
#The first step is to understand a business and the second step is to find it to be good; then valuation
Putting forth my
benchmarks so bluntly—8, 7, 3, and 3—is a little dangerous and potentially misleading.
It’s dangerous because it could be interpreted to mean that it’s OK to cut right to valuation without first
understanding a business and
seeing if it’s good. Many investors do that. And it can work. But with that approach mine are not the benchmarks to use.
Summary
Inexpensiveness can be detected with
four different price metrics:
1. Times free cash flow (MCAP/FCF)
2. Enterprise value to operating income (EV/OI)
3. Price to book (MCAP/BV)
4. Price to tangible book value (MCAP/TBV)
