In their book, "Strategic Value Investing: Practical Techniques of Leading Value Investors," authors Stephen Horan, Robert R. Johnson and Thomas Robinson argued for a more nuanced approach to value investing.
In chapter six, the authors take on valuation and valuation processes as well as measures of absolute and relative value. In effect, a deep dive into the drivers of what Warren Buffett (Trades, Portfolio) would call a wonderful company at a fair price.
So far in the book, they have made a distinction between intrinsic (or fundamental) value and market value (price). But that is only scratching at the surface since, according to the authors, “value is in the eye of the beholder and is dependent upon how the assets are deployed or might be deployed. For example, a company generally has one value if it is to be immediately dissolved and another if it will continue in operation.”
Here are the most common valuation metrics:
- “Going concern value” reflects what a company would be worth if it will continue to operate.
- “Liquidation value” shows what a distressed company would be worth if its assets were broken up and sold individually (and often under duress, as the authors remind us).
- “Fair market value” differs from liquidation value because it reflects what the company would be worth if sold by a willing seller to a willing buyer (no duress).
- “Investment value” reflects a company’s value to investors who are buying and includes any synergies that may arise out of combining different assets.
- “Replacement value,” as the name suggests, refers to just the cost of replacing assets and does not involve any synergies.
The authors added, “In most cases, we will want to determine the intrinsic value of an investment independently of the quoted market price of the company. We can do this for most securities using an absolute valuation model.”
Absolute valuation models
In these models, an investor analyzes the company only; the industry and economy are mostly ignored.
Investors begin calculating an “absolute” value by estimating the future cash flows of the company. Next, they arrive at an intrinsic value by discounting the future cash flows, using the rate of return required by the investor.
Discounted cash flow models are similar to dividend discount models, where future cash flows are the expected dividends.
Absolute value also can be established by putting prices on the underlying assets, a valuation commonly used where a firm is in a distressed situation. It may also be used in cases where a company would be worth more broken up and sold than continuing as a going concern. In past decades, many conglomerates have been broken up to capture additional value for shareholders.
In the financial sector, absolute valuation may be based on the “residual income model,” where valuation is based on earnings rather than cash flow.
Relative valuation models
Absolute valuation models do help us value assets such as stocks. But is the stock we’re analyzing our best investment opportunity? To know that, it’s necessary to compare this stock with its peers and with all other investment opportunities available. Once we begin comparing one stock with another, or other securities, we enter the realm of relative value.
For example, investors commonly use price-earnings ratios to sort stocks. A company trading at a lower multiple to earnings—let’s say at a price-earnings of 12, while its peers trade at an average of 15—appears to be a better value than its peers (all else remaining equal).
What the price-earnings ratio tells us is how much investors are willing to pay for each dollar’s worth of earnings. When reading price-earnings ratios, check to see which variation is being used: trailing 12-month indicates a ratio based on earnings of the previous 12 months, forward price-earnings is based on an estimate of earnings for the next 12 months and normalized price-earnings is based on earnings averaged over the most recent and full business cycle.
Another important relative valuation model is the market-to-book ratio, which is also called the price-book ratio when referenced on a per-share basis. Regardless of the term, the number is the same, and it is reached by summing up shareholders’ equity, preferred stock, deferred taxes and any investment tax credits shown on the balance sheet.
Typically, book value is less volatile than earnings, or as the authors put it, less vulnerable to statistical noise. But, they added, it is a “very crude measure of value”. Among New York Stock Exchange-listed stocks in June 2011, the median price-book ratio was 1.73, indicating investors were willing to pay $1.73 for every dollar of book value.
Price-to-cash flow is another alternative to the price-earnings ratio and is used in analysis because it removes potential distortions that might be caused by companies using alternative accounting conventions or by management manipulation of earnings.
Yet another approach that avoids the noise of price-earnings ratios are valuations based on dividend yields, which are less volatile than cash flows. Management has the power to change dividends, but, in general, almost all companies want to gradually increase dividends over time; failure to do so reflects badly on them.
The median dividend yield among New York Stock Exchange-listed stocks in June 2011 was slightly above 1.5%. Companies with yields above 6% are thought of as deep-value stocks (this often reflects low market prices rather than high dividends).
The authors also reported that dividend yields had declined over the previous 60 years as companies increasingly reinvested free cash flow into their businesses instead of paying it out as dividends.
The relative metrics described above are the most commonly used, but there are yet others:
- Price-sales ratio eliminates possible distortions in the calculations of earnings.
- Price-to-Ebit (earnings before interest and taxes) ratio shows a valuation based on operating income.
Conclusion
This section of chapter six has focused on understanding the valuation measures underlying the concept of intrinsic value. Some of the measures are absolute, which reflects what the stock would be worth if considered on its own merits. Other measures are relative, meaning the value of a stock is considered in relation to other stocks, especially its peers.
And, as the authors concluded:
“No single, authoritative method for measuring value exists. Everyone, it seems, has a different notion of value. That is part of the art of investing. In this chapter, we showed that the concept of value can have several dimensions: replacement value, market value, and liquidation value, for example. Similarly, distinguishing between value stocks and growth stocks is not a straightforward exercise. It is a judgment informed by a variety of different metrics. A preponderance of indicators pointing in the same direction, however, can give the strategic value investor confidence in his or her assessment.”
Read more here:
- Â Strategic Value Investing: The Valuation Process
- Strategic Value Investing: Company Analysis, Part 5
- Â Strategic Value Investing: Company Analysis, Part 4
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
