Intelligent Investing
How Not To Do Valuation
Valuation is an estimation of how much a business is worth to a sensible buyer and there are many ways to value a business or stock by looking at its assets, liabilities, how much cash flow can be generated from those assets, industry dynamic, competition and so on.
Instead of writing about how to do valuation, I will do the opposite - How not to do valuation. Just as we can earn outsized return without any superior insight simply by reducing mistakes; we can benefit from learning the wrong way of doing valuation so we can avoid making them. The benefits are twofold. One, you will avoid making those mistakes. Second, when you notice someone doing these stuff in their write up, it raises your skepticism.
"It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent." -Charlie Munger
Earning Per Share x Price Earnings Ratio
The most common way people value a business is using the estimated eps times the P/E ratio. I’m not sure where to begin to explain what's wrong with this equation but it is the most abused formula. This is not valuation. It is fooling yourself. This is using hammer to type on a keyboard.
|
A |
B |
|||
|
2016 |
2017 |
2016 |
2017 |
|
|
EPS |
$0.50 |
$0.90 |
$0.50 |
$0.60 |
|
P/E Ratio |
12x |
10x |
||
|
Fair Value |
$12.90 |
$10.60 |
Here are 2 stocks. Stock A grown its EPS by 80% while stock B only grows by 20%. Which is better? Many investors would prefer A over B since it has higher growth rate, therefore it justify a higher PE ratio of 12. Many would call it conservative and prudent and start finding peers that sells at higher PE to justify the purchase.
But if you ask me, I’ll need more information. What is the return?
|
A |
B |
|||
|
2016 |
2017 |
2016 |
2017 |
|
|
Equity Per Share |
$5.00 |
$10.00 |
$4.00 |
$4.60 |
|
EPS |
$0.50 |
$0.90 |
$0.50 |
$0.60 |
|
ROE |
10.0% |
9.0% |
12.5% |
13.0% |
Now we have the total equity, this will give us a clearer picture. It seems that stock A doubled their investments into the business, which explains why EPS has gone up by 80%. Whereas stock B only invested 15% more and generated an extra 10 cents EPS. Look it this way, stock A ROE actually dropped while stock B has done the opposite. Put it in plain English, every dollar spent on stock A will return 9 cents while for B that’s 13 cents. Worse, you are paying a higher P/E for stock A. Now, is paying a higher PE for a stock with lower ROE conservative? We don’t need to go further to see how absurd is this.
Have you ever get excited because your savings account grows every year without putting any extra money into it? I don’t, because the return is always 3%. It can go from $100 to $1 mil given long enough time but I won’t be too excited to add more money in because I know the return is low.
Ignoring return & cost
Growth rate, like the example above, is the most beloved terms. There’s a lust for it. But that’s not the be all end all thing in valuation. Just like you need more calories to grow your body by eating more, same applies to business. If a business is growing, you have to ask - What is required to achieve that? Return on equity, or return on invested capital is the key driver that connects the whole thing.
A business can grow to the sky and back but if it requires the same amount of extra investment to match those growth, it is no more valuable than before the growth. If you don’t get this sentence, you should read it again. And don’t take my word for it. Real cases are everywhere. You can find many stocks that beats Public Bank and LPI Capital in term of growth rate. Public Bank, which is at best growing at 6-7% a year, but why is it constantly selling at PE 15-17 whereas those high growth small caps sell below PE of 10? Because Public Bank is overvalued and the rest are hidden gem? No. That’s because Public Bank can generate a consistent high ROE for a long long time. Wellcall is another. It doesn’t need to grow a lot to justify a high valuation because it can generate a high return for every dollar invested. Maxis, Digi, Dutch Lady, the list goes on and on, they are all laggards in growth compared to small mid cap stocks but persistently selling at higher valuation.
What do we mean by high ROE? What is high and what’s low? That’s where you have to look at the cost side or opportunity cost. Cost of capital is the cost of forgoing other investment opportunities that can earn a similar return. If a business borrows from banks to grow their business, there’s the cost of interest they have to pay to the banks; if they ‘borrows’ from the market in the form of equities, the cost comes from shareholders committing to this investment and not able to invest their money elsewhere.
Growth is only valuable if it is above the cost of capital. If cost of capital is 10%, a same amount of return will not generate any value and one below that will destroy value. Now, there will be people saying this is too academic, too accountant, lack of business sense, or “you can’t measure cost of capital so why bother”. Well, if today you going to go out there and invest $10,000 to open a sugarcane stall and earn $300 every year for the next 3 years while the Public Bank banner across the street offer 3% fixed deposit p.a, and yet you are happy to stick to your business - you should start questioning your business sense. You can ignore something but that doesn’t mean it is not there.
Quick quiz. What is the reason that Pensonic trade at P/E 10 despite doubling revenue over the past 10 years? Because it earn crap return and destroying value. Your money is better invested elsewhere.
If you can throw away everything about investing and learn one thing - That will be thoroughly understand the return of every dollar of invested capital. A simple concept yet it is the cornerstone of investing.
Multiples
Besides PE, other popular multiples we use to do valuation include EBIT, Cash Flow Multiple etc. There are nothing wrong with multiples. But multiples are meant for screening or as an crosscheck/triage, not valuation. Screening is what you do at the start, valuation is done at the end. So don’t mix those 2 things up. But the popularity of multiples is obvious. It is simple and easy to use. You can explain it to yourself and sell to others easily as a story. It is elegant enough for back of envelope calculation. And thus lending itself to be abused in a blanket fashion.
Short-term horizon
There’s a tendency to do valuation by looking into the next few quarters and estimate the EPS. The main reason investors refuse to do long term forecast is because no one can predict what will happen 5-10 years from now therefore it is a waste of time.
What is valuation? Can you value fine arts like an 18th century painting or how about a Ming dynasty bowl? You can’t. Their valuation will depends on how much the next buyer is willing to pay. It is speculative. However, stock is different. A business have cash flow generating assets, therefore we can value it from the cash flow those assets are expected to generate over its entire lifetime. Read this again if you don’t get it.
So if valuation is dependent on the sum of these cash flows generated over its entire lifetime, how is it possible for you to do valuation by looking at few quarters or a year? And again, because it is hard to predict what will happen 10 years from now doesn’t mean you can ignore it. Why is Amazon selling at such a hefty valuation despite reporting razor thin profit? Because the market is looking at its future potential. Market is forward looking not in term of quarters but years. Why is Grab valued at $3B? Are you able to give Grab a valuation by projecting its profit & loss statement next year?
Conclusion
If you can take one thing away from here, that is always ask “What is the cost?” What is the cost for growing? A company can grow its revenue 9x but if it requires 10x of extra investment to do that, it is a rubbish investment. 2nd level thinking is not some deep mysterious thinking ability, you simply have to be more curious and ask more. And when you do valuation, you need to separate speculating from investing. There’s nothing wrong with speculating, everyone does it including me although I don’t endorse it but at the same time, I know my bad track record of convincing people. So if you going to do it, make sure you keep both eyes wide open. The second you start mixing speculating with investing; the second you start believing you have your swimming pant on but in fact it is long gone, you are in a lot of trouble ahead.
“The first principle is that you must not fool yourself – and you are the easiest person to fool.” - Richard Feynman
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Discussions
15 people like this. Showing 36 of 36 comments
I find myself benefit greatly from this article, it open my eye!!! Thanks Rick.
2017-04-08 10:30
As investor u need to understand growth v value when u invest and at the end u still need benchmark....the equivalent IRR rates loh...!!
Say u bought a stock with a historical 30% growth and at a PE 35%....is it better than a stock with PE 6x with no growth leh ??
It is very subjective loh.....bcos for growth stock....u need to ask yourself....how long the growth can sustained loh ??
Say there is 50% probability the growth can sustained at 30% over next 3 yrs worthwhile and then taper of to 10% over next 2 yrs....then flat return or not ??
For the value stock...if 50% can sustain the eps at PE 6x for next 5 yrs....which one will u pick leh ??
Assuming risk free interest rate at 3% pa loh..!!
Conservative investor will pick the value stock...bcos it is already giving a high earning yield of 16% pa based on PE 6x.
For growth investor...they look at the growth upside...the EPS will double 1st 3 yrs and then gain another 30% the next 2 yrs loh...!!
Raider will prefer to chose option 1 the value stock....bcos it already giving good return with above 16% pa yield although without eps growth loh.....!!
But there is uncertainty....notice the probability is 50% apply for both stock loh.....!!
Still it is better to invest then not invest bcos the alternative risk free rate is only 3% pa mah....!!
2017-04-08 10:50
this comparison is too crude..P/E is being prejudiced again:(
we need to know how did the Equity of Company A went up so high resulting in reduced ROE despite a phenomenal increase in earnings..
2017-04-08 12:46
very true...all this Cost of Capital..doctorate lectures is indeed useless in practical sense...its all about relative valuation...at the end you are comparing with risk free interest rate....and if at all you need to consider more variable (internationally) - u can add the currency direction as factor.
Posted by stockraider > Apr 8, 2017 10:50 AM | Report Abuse
As investor u need to understand growth v value when u invest and at the end u still need benchmark....the equivalent IRR rates loh...!!
Say u bought a stock with a historical 30% growth and at a PE 35%....is it better than a stock with PE 6x with no growth leh ??
It is very subjective loh.....bcos for growth stock....u need to ask yourself....how long the growth can sustained loh ??
Say there is 50% probability the growth can sustained at 30% over next 3 yrs worthwhile and then taper of to 10% over next 2 yrs....then flat return or not ??
For the value stock...if 50% can sustain the eps at PE 6x for next 5 yrs....which one will u pick leh ??
Assuming risk free interest rate at 3% pa loh..!!
Conservative investor will pick the value stock...bcos it is already giving a high earning yield of 16% pa based on PE 6x.
For growth investor...they look at the growth upside...the EPS will double 1st 3 yrs and then gain another 30% the next 2 yrs loh...!!
Raider will prefer to chose option 1 the value stock....bcos it already giving good return with above 16% pa yield although without eps growth loh.....!!
But there is uncertainty....notice the probability is 50% apply for both stock loh.....!!
Still it is better to invest then not invest bcos the alternative risk free rate is only 3% pa mah....!!
2017-04-08 13:35
great clarification to me from this article. question pop up in mind and greatly answered by raider. double benefits. very done raider and ricky...
2017-04-08 15:06
Tell me if risk free rate doesn't form the leg of cost of capital then what is?
2017-04-08 15:07
Ricky Yeo is another good talker, all talk only but never proved his skill in picking up good stocks CONSISTENTLY.
2017-04-08 15:10
Ricky, until you proved your investment skills, all your opinions are still your personal opinions.
2017-04-08 15:13
Don't question me if I contribute anything, I do not come here to teach people, I come here for stock information, not school materials.
2017-04-08 15:13
yes Risk free rate forms the leg of COC....but that should be the only leg. all others are incorporated for nothing but considering risk factors only.
Thus if one really look at buying stock as buying a piece of business...and depending on 'how much he knows the business' these 'additional factors to consider risks' which are incorporated into the risk free interest rate can easily be evaporated...
2017-04-08 15:15
ricky
thanks for a fine effort but,
DCF can be used to justify practically any price that needs justifying.
Analysts are a very creative lot....even if they are not very good at making you rich.
2017-04-08 15:23
Don't quite get you. You saying only risk free rate should be used but not other stuff like risk premium?
@ Cikgu Zhang, this is mental model not philopshy
2017-04-08 15:27
Ricky, actually i am saying..
there is even no need to bring the risk free rate into the picture...as it does not really add value to the decision making of stock selection...as you are just comparing the end value of the cash you will receive (accumulate) with the cash your forked out and compare this CAGR with a reference minimum achievable CAGR.
I dont see an issue of it (risk free interest rate or COE) being any arbitrary value... when its about stock comparison and selectivity...provided you are able to & are predicting the FCF-E flows in the future accurately with certainty.
2017-04-08 15:35
ok all, that's why I title this 'How not to do valuation' not how to. If I write it as how to, there will be countless valuation methods that can be use besides DCF depending on the business. DCF is a model, thus it is not perfect, everyone needs to understand its limit, so does every other valuation model out there - Dividend model, Ben Graham model, Steady State + Future State valuation, Net-net, assets-based, reverse DCF etc.
But the more pressing problem is people not considering the cost side of growth.
2017-04-08 15:36
Please elaborate more on this "But the more pressing problem is people not considering the cost side of growth."..
your sharing is definitely appreciated...as it stimulates contrary thinking..he he
2017-04-08 15:39
ok probability, you are right, it is all about how much you put in vs how much you can take out.
If there's 2 investment, one you put in $100 now, and you get $200 (including principle) by year 5, in between you don't get any.
Another you put in $100 as well, and you get $20 Yr1, $20 Yr2, $20 Yr3, $20 Yr 4 and $20 + $100 principle on Yr 5.
Both have the same amount of in and out, same CAGR, would you value both differently or the same?
2017-04-08 15:48
Ricky...i would go for second investment (co. B), but that's provided the following:
- company B provides dividend cash flow as you had mentioned above
- & there are no other potential investment with CAGR higher than CAGR of Co. A &B that i can use the Dividend to reinvest....if co. B is the only second option i have i will reinvest dividend in Co.B.
but in reality how many company pay dividends...and do we really need to make our standard reference COC at 10% value? why not go for 20%?
and whats the average return of BURSA? thats like risk free interest rate right?
again...my decision making to select Co. A or Co. B did not take any consideration on any absolute COC...its only relative valuation.
2017-04-08 15:58
yea dont worry about whether it is dividend or not. If both are a sure thing, majority would go for 2nd over 1st even though CAGR wise, both are the same.
And you are right you get those amount out to reinvest whereas on 1st case you have to wait to year 5. It is time value of money concept. We discount them differently because the difference in the timing of cash flow. It is a form of opportunity cost. You get compensated earlier for 2nd than the 1st.
2017-04-08 16:30
a very high COE in your valuation will cause us to over-appreciate dividends....imagine if instead of paying dividends, Co.A chose to reinvest on their own business which provides say g = ROIC x RR = 20% x 40% = 8%......one may under-appreciate this growth of Co.A though it is evidently visible as 8% compared to Co.B if one values Co.B by sticking to COE of 10% having seen the dividend payout of 40%.
(Assume the dividend payout rate of co.B is the same as Co.A's reinvestment rate but without any re-investments taking place in Co. B due to lack of scope/opportunity).
I am saying dividends are over-appreciated because in reality it is not true that we can make returns more than 8%....when one can see what has been the average market return is here in Malaysia. Lets not compare Bursa with U.S.
2017-04-08 16:46
Stop misleading ppl la who says you cant use PE
I pity all the aunty's and uncle's and general public who read this who are going to dismiss earnings multiples
There's a thing called Fundamental PE, google it and let Damodaran lead the way. It ties in all the ROC/ROIC/ROE and costs of capitals (ie 'excess returns'), with growth, and how a deficit actually destroys value when you grow etc
When it comes to the mathematical / theoretical, the very foundations of intrinsic valuation, youre weak. You need to ask yourself, how many years have you been doing this, and if you read and spent that much time but still do not 'see' or are able to 'connect' these concepts......
Youre a pro or youre a noob, thats life
2017-04-08 16:51
Probability I know there are many things we can discuss, the topics are endless. I am just showing you everything else the same, you would prefer B over A, even if both are bonds, because you are taking into the consideration of opportunity cost right?
2017-04-08 17:29
Valuelurker, good to see you are back again. You either understand the article or you don't, or read again, that's life indeed.
2017-04-08 17:31
Ricky, very good article, like your style of writing. ...keep it up and ignore some "mean" comments here to condemn.
I totally agree that cost of capital must be considered into the growth story.
2017-04-08 17:38
You guys dont shoot jt yeo so much la. Although he has no track record in i3, he has posted many good articles which content is original. Please keep up the good work! One must remember investing is not just about making money. It is also about learning.
2017-04-09 06:14
Assuming every thing is equal in 2 comparative companies, you will give a higher PE to the stock with the higher ROE.
It is better to own a great company at a good (fair) price than a good company at a great (cheap) price.
Why do you wish to pay a higher price (higher PE) for a company with lower ROE when you can pay a lower price (lower PE) to acquire a company with higher ROE, which is a better company, assuming everything is equal?
2017-04-09 06:27
WHETHER GO FOR HIGH ROE WITH HIGH PE OR LOW ROE WITH LOW PE INVESTMENT.....ALL THESE COME TO A SINGLE COMPARISON FOR ALL....THE EFFECTIVE INTERNAL RATE OF RETURN OR IRR OF YOUR INVESTMENT LOH..!!
FOR EXAMPLE BOND THAT PAYS 6% PA....BUT TRADE AT RM 0.50 MEANS U R GETTING PE 8X EFFECTIVE YIELD OF 12.5% LOH.....!!
A STOCK THAT TRADE AT RM 50.00 WITH ROE 60%....WITH EPS OF RM 0.20.....U R GETTING PE 25X OR EARNING YIELD OF 4% PA....BUT U NEED TO FACTOR IN THE POTENTIAL GROWTH IF ANY IF U PAY A PREMIUM PRICE FOR THE INVESTMENT.
A STOCK THAT SHOW ROE 6% PA BUT TRADE AT RM 0.40 BUT WITH EPS OF RM 0.07 WITH NO GROWTH....MEANS THE STOCK HAVE PE 6.7X OR EARNING YIELD OF 15% PA.
NOW U TELL ME WHICH INSTRUMENT U WILL BUY OUT OF THE 3 CHOICES ??
2017-04-09 11:19
Posted by Flintstones > Apr 9, 2017 06:14 AM | Report Abuse
You guys dont shoot jt yeo so much la. Although he has no track record in i3, he has posted many good articles which content is original. Please keep up the good work! One must remember investing is not just about making money. It is also about learning.
Good on you Flintstones for coming out with a very good comment.
Come on, this is a very good article, and JT is sharing it here. It deserves good comments.
I cannot imagine there is someone who posted such a comment below. In my opinion, JT Yeo is a much better investor than him, whether theoretically or practically.
Posted by valuelurker > Apr 8, 2017 04:51 PM | Report Abuse
Stop misleading ppl la who says you cant use PE
I pity all the aunty's and uncle's and general public who read this who are going to dismiss earnings multiples
There's a thing called Fundamental PE, google it and let Damodaran lead the way. It ties in all the ROC/ROIC/ROE and costs of capitals (ie 'excess returns'), with growth, and how a deficit actually destroys value when you grow etc
When it comes to the mathematical / theoretical, the very foundations of intrinsic valuation, youre weak. You need to ask yourself, how many years have you been doing this, and if you read and spent that much time but still do not 'see' or are able to 'connect' these concepts......
Youre a pro or youre a noob, thats life
2017-04-09 13:48
Is this article "How not to do Valuation" akin to much ado about nothing or "cannot see the wood from the trees"?
Nevertheless I do like the conclusion though which aptly sums up this article
“The first principle is that you must not fool yourself – and you are the easiest person to fool.” - Richard Feynman
Fooling oneself in this article is going about the convoluted way in thinking that a clear message had been brought across but ended up in opaqueness.
There are two basic topics here which was not addressed to adequately
- Basis of determining Intrinsic Valuation
- Efficiency of capital usage vs its cost of capital
I would not wish to dwell into the topic of determining intrinsic valuation. However I am rather intrigued by the writers discussion on efficiency of capital usage without reference to its cost of capital.
I am rather surprised on why ROCE was not brought into this article.
As some of us may very well know, the return on capital employed measures the proportion of adjusted earnings to the amount of capital and debt required for a business to function.
For a company to remain in business for the long term, its return on capital employed should be higher than its cost of capital
ROCE is commonly used to compare the efficiency of capital usage of businesses within the same industry( I presume the writer is comparing A & B within the same industry)
ROCE is a better measure than return on equity, because ROCE shows how well a company is using both its equity and debt to generate a return whereas ROE ignores debt.
2017-04-09 14:44
Hi you are right, ROE is not the best if you compare it to ROIC or ROCE. My purpose of writing is targeted towards investors that are new to the concept of return. So taking into that consideration, I choose to brush through most of the things and keep it simple, and as always, when you keep things on a high level, you will miss out a lot of 'what ifs'. And I do so to avoid overwhelm readers. And any reader like you that is familiar with this concept will definitely find me oversimplify and generalize things
2017-04-09 19:12
ricky/JT is a very good fundamental sifu, same like KC Chong sifu.. those who condemned him do no really understand why ricky is trying to say... i feel sorry for these ppl...
2017-04-19 15:22
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A very good article and very accurate, Keep it up!
2017-04-08 09:43