Berkshire Ruminations

Tuesday, May 29, 2007

A Valuation Rumination

Some folks consider themselves value investors if they tend to buy stocks with a low P/E. I think this is superficial, but it highlights what may be a pervasive oversight that all types of investors make: We often forget what stock is and why anyone would be willing to pay money to own it. In the lines that follow, at the risk of ultimately just playing with words, I will try to articulate my opinion of where value comes from and thus what constitutes value investing. At least in the Graham-Dodd sense of the term.

Companies operate to make money. No business would exist, except in some alternate bizzaro (or maybe socialist) world, if that wasn’t its goal. Hence, earnings are important. But they are not all that is important. Further, earnings themselves do not represent value. Rather, they are the source of value. Graham and Dodd cared about earnings only to the extent that they increased the firm’s value and the firm’s value, to Graham and Dodd, came directly from the balance sheet. By adopting their definition of value, return on equity, not earnings alone, is the most important metric of value creation.

Graham and Dodd focused on purchasing companies that traded at a discount to book value. That is, they preferred stocks whose market cap was less than the book value of that firm’s equity. This was logical since they saw the stock as representing a claim – a residual claim, mind you – on the company’s net assets. If the company were to liquidate today, the stock ought to be worth today whatever would end up being paid to the shareholders. Sell the assets, pay off the debt, what ever is left over (net assets) is what the company is “worth.” If we can get it for less than that, we are getting a bargain. So the only real consideration in this simple scenario would be any discrepancy between the actual market value of the assets and the value at which they are booked on the balance sheet.

Think about this concept for a moment. If you knew a company was going to instantaneously liquidate at 3:00 pm this afternoon, how much would you pay for it at 11:00 am this morning? Answer: net asset value per share.

But what if the company doesn’t liquidate today? What if, instead, it liquidates in twenty years? What if it never liquidates? The principles of valuation ought to be the same, Graham and Dodd would suggest, but the calculations get tremendously more difficult. Again, the company is worth the value of its net assets, but now we don’t know what that value will be in the future. Additionally, because of the time value of money, we must discount that unknown value back to the present at some other, also unknown, discount rate. Oh yeah, and the number of periods we are discounting that unknown value at an unknown discount rate is also unknown.

Maybe by now it is clear that, despite the uncertainty, at least we know that what really drives the value of a stock is the claim that the stockholder has on the company’s assets. If not, consider the valuation of a bond, which also represent a claim on the company’s assets. Bonds are simpler to value, though, because there is far less uncertainty as to what the owner will be paid. At maturity, bonds are “liquidated” just as our stock was in the above hypothetical. The value (price) of the bond is simply the discounted value of all those payments.

Earnings are important because they boost the stockholder’s claim on the firm’s assets. This results from retained earnings. As the company books profits, those profits are retained on the balance sheet, boosting asset value without a corresponding increase in liabilities. So shareholders’ equity (book value) increases. We measure this rate of increase by the return on equity. The problem is that we don’t know how much the company will earn so we don’t know how much book value will increase. Note that the payment of dividends is only a minor complication – instead of value being retained by the company for eventual, indefinite payment to the shareholder, it is paid out immediately. Either way, it ends up in the shareholder’s pocket.

But not all earnings are created equal, and this is probably the important part of my musing. Not all earnings boost book value. If net income cannot be retained or paid to shareholders as a dividend, then it can’t increase book value of equity. And there are simply too many ways that net income can be manipulated (willfully or not) so that it does not accurately reflect the value added to the balance sheet. Additionally, that unknown discount rate that I alluded to earlier ought to be based the firm’s cost of equity. If this cost of equity is high, then a firm can actually be destroying value even as its net income grows.

First of all, it is logical to discount future net income at the firm’s cost of equity, rather than its weighted average cost of capital (WACC), because the net income number is already net of the cost of debt. I see a lot of students who have been taught capital budgeting (a similar-but-different exercise) try to discount such numbers at the WACC. Cost of equity is a somewhat abstract concept and is often difficult to calculate. At the very least, though, we can say that it is some modest amount higher than the interest rate the company pays on its senior debt, since equity is much riskier to its owner than is debt.

If we assume that we are discounting that future income at the cost of equity, then the firm must boost its book value at a rate greater than this cost of equity if it is to create value. That is, it must earn a return on its equity that is higher than its cost of equity. Otherwise, even though we have future positive net income to add it to our current book value, after discounting to reflect its cost it is worth zero or less.

Graham and Dodd’s notion of value has several other implications. One is that a profitable company should not sell for less than the market value of its net assets. If it does, it is a bargain. But the market does some quirky things and occasionally this happens. It happened frequently when information gathering was as difficult as it was in Graham and Dodd’s era, but probably happens far less often today. Graham and Dodd idealized a bargain in what they called a “net net stock,” one that sold for less than the value of its net working capital. These were tremendous bargains that are all but nonexistent in today’s market.

I guess the bottom line is that ROE, not P/E is the most important ratio in stock analysis. A value investor, though, realizes its importance because he realizes where the value of a stock comes from.


  • Andy,

    You write:

    "Think about this concept for a moment. If you knew a company was going to instantaneously liquidate at 3:00 pm this afternoon, how much would you pay for it at 11:00 am this morning? Answer: net asset value per share."

    This assumes of course that the firm must be liquidated. In the real world though, companies are hardly ever liquidated (even in bankruptcy court).

    If we assume that most investors are buying stock in companies that are never going to be liquidated, and you rephrase the question accordingly:

    "Think about this concept for a moment. If you knew a company was going to put itself up for sale at 3:00 pm this afternoon, how much would you pay for it at 11:00 am this morning?"

    Wouldn't your answer be very different? Isn't the reason why investors consistently pay prices above net asset value (not a single S&P 500 stock trades below net tangible asset value) because of future growth potential? I think we pay a multiple of earnings to account for the fact that earnings could grow in the future.

    If we just look at a balance sheet, we are only getting a snapshot in time. Since stocks give us a claim on future earnings, a snapshot from the past is less helpful. While I don't disagree that Graham and Dodd thought in the terms you describe, I would postulate that a stock need not trade below the value of its assets to be considered a value stock (i.e. to be undervalued). If that were the case, there would be no value investors due to lack of investment options in the public markets.

    Don't you think that might be why P/E ratios are used much more often than ROE ratios?

    By Blogger Chad Brand, at 29 May, 2007 15:44  

  • Chad,
    Re-read my post because I think you are missing the point. Value comes from the numbers on the balance sheet. But those numbers on the balance sheet will be higher in the future because of growth. This, and this alone, is why we pay a premium to book value. Never did I suggest that only stocks that sell below book are value stocks. You would be correct if I had, because that rarely happens. Nor did I suggest that we look only at that backward-looking snapshot. What I am suggesting is that it is the process of those future earnings causing book value to grow that increases firm (and thus stock) value. If the discounted value of those future earnings (and thus future book value) is greater than the current price of the stock, then the stock is a value stock.

    By Blogger Andy Kern, at 29 May, 2007 16:21  

  • I think I understand the point, it's just that if ROE is more important than P/E than we have to value companies based on predicted future book value, not future predicted earnings. That seems like a much tougher task. Not only do we have to know how much money is going to come in (which is hard enough), but also how it will be used going back out.

    Since that is a daunting task, I think investors focus on earnings. As long as other investors are using P/E multiples to value stocks, and those investors are the ones who will be buying your shares in the future when you decide to sell them, I think the income statement is more important than the balance sheet when valuing companies.

    I'm not sure though, if your piece was meant to simply explain Graham and Dodd, or to also give a reason why investors should use that mentality when investing their own money. If it was the latter, I guess I would need more convincing. :)

    By Blogger Chad Brand, at 30 May, 2007 07:22  

  • Chad

    It seems to me you need to first make distinction between investing and speculating. Investing as defined by Graham and Dodd as seeking both a reasonable return on capital, and a high probability of return of capital (i.e. don't lose money).

    If the liquidation value of a company is more than market value of equity, either the assets will be employed effectively or someone will break the company up and enrich the shareholders. That's the economic value of corporate raiders - indeed just knowing raiders are out there will motivate management to be proactive. So book value (to the extent it is a proxy for liquidation value) establishes a floor under stock price and ensures return of capital. Note that this does not depend on someone else paying more for the stock in future since can always create the value yourself via discontinuing the business.

    You correctly point out that most people use P/E - but Graham and Dodd would put that into category of speculation. If your plan is to sell to someone else who will pay more for the stock in future you are speculating. What if they don't cooperate? There's nothing wrong with speculating - you can make lots of money doing it (witness guys like Soros) but you get into trouble if you confuse speculation with investing.

    By Blogger Michael, at 30 May, 2007 07:53  

  • Chad,
    It is a much tougher task (to predict future book value as opposed to simply future earnings). That is why Graham and Dodd also preached the importance of having a margin of safety. But don't misunderstand. I see earnings and thus P/Es as extremely important, after all it is future earnings that determines future book value. But equally important is the cost of those earnings, i.e. the cost of equity. A firm with an ROE of 5% but a cost of equity of 10% could have wonderfully growing earnings while not creating any value at all. One detail I didn't mention but probably should have is that this type of analysis is only useful on firms with modest amounts of debt -- too much debt will inflate ROE while putting the firm in a much more precarious financial situation.

    I think you are absolutely right and maybe you did a better job of stating my main point. The value of stock comes from the legal claim that a stockholder has on the business - that of the residual value after liquidation. Thus, from a conceptual standpoint, that is basis of any valuation.

    Thanks for the comments. This is fun to debate.

    By Blogger Andy Kern, at 30 May, 2007 08:15  

  • Indeed, Andy, it is a fun debate, so I'll continue my thought process...

    "If your plan is to sell to someone else who will pay more for the stock in future you are speculating."

    I respectfully disagree with that statement. Every single person who buys a stock is planning on selling it in the future to someone who will pay more for it than they did. That's what investing is all about.

    As investors, we buy stocks that we feel are undervalued (i.e. they will be valued by the market in the future at a substantially higher price). By Michael's definition though, that is speculating, not investing?

    We will probably have different definitions of those terms, but I think the main difference between investing and speculating is the margin of safety that you speak of. A high margin of safety indicates the odds are high that you will not lose money. Without a margin of safety it is more like flipping a coin, playing the lottery, or going to a casino. Sure you can win, but the deck is not stacked in your favor.

    Buying stocks with low valutions is an example of investing, not speculating. The odds are dramatically in your favor that you will achieve above-average investment returns. Making a bet on a biotech stock before the FDA issues an approval or rejection is speculating. The key distinction is having an attractive risk-reward scenario, coupled with having a high probability that your investment thesis proves accurate.

    I understand that using book value as a proxy for liquidation value confirms your margin of safety, but in a world where 99.9% of companies are never liquidated, that reasoning is something that shows up in textbooks, but not in real life. How many corporate raiders buy and liquidate? Hardly any, but they aren't speculating in most cases either.

    By Blogger Chad Brand, at 30 May, 2007 10:06  

  • Chad

    I find myself respectfully disagreeing with your respectful disagreement.

    If I buy an apartment building that throws off cash, intending to keep the building until I die and then leave to my children, I can get a perfectly respectable return without ever selling to anyone. If I buy a local carwash that is profitable, I don't need to sell to make the investment a good one. Similarly, if I buy shares of Citigroup and am confident in the dividend and long term prospects for it's growth, I don't need to sell to make the investment a good one. All could be investments as defined by Graham and Dodd, none are speculations.

    On the other hand, since I know nothing about medicine or FDA approval process, buying a company that depends on some future FDA approval for me is gambling, not even speculation. If you are more medically savvy, understand what is going on and believe you can reasonably estimate the FDA approval, maybe it's a good speculation for you, but cannot be an investment for anyone.

    Warren Buffet says his favorite holding period is forever. That't extreme, but think of it this way - if markets close today for next 5 years, are you confident that all your "investments" will be worth more at the end of the 5 years when you get the option to sell? Of if markets never open again, how confident are you that you could sell to a Blackstone, Texas Pacific, or similar private transaction type buyer and recoup your "investment" in the company?

    When I buy a stock, it's not to sell to someone else per se. I don't pull trigger unless I'm comfortable holding for the long term (for me, nominally 5 years plus). Of course if Mr. Market makes me an offer that is more than fair, I'm happy to accomodate him earlier, but I'm ok just buying and holding.

    By the way, a large fraction of people out there who describes themselves as "investors" would be a speculator by Graham and Dodd definition. The reason corporate raiders don't buy and liquidate today is because valuations are so high in market there's not much there to raid. That's a function of today's (in my view irrational) market valuation, but doesn't change the principle that specuation and investment are different enterprises entirely.

    By Blogger Michael, at 30 May, 2007 10:55  

  • Chad,

    I am not sure we are really disagreeing. But I do think you are getting hung up on the concept of liquidation as the basis for value. No company need ever liquidate for stocks to have value. But without the guarantee that, if that were to happen, the shareholder would be paid, then a stock is nothing more than a piece of paper. This is why, for instance, the price falls to zero when a company has to cancel its shares as part of a reorganization. The shares no longer represent a claim on the firm's assets so they no longer have value and are nothing more than a piece of paper.

    If someone arbitrarily assigns that paper a price, without regard to what that paper represents, in the hopes of convincing someone else to pay a higher price in the future, then he is "speculating." Conversely, if he buys a stock realizing that it is much more than just a piece of paper and actually represents a legal claim on the firm's net assets, he is investing. But that is just my opinion.

    By Blogger Andy Kern, at 30 May, 2007 11:10  

  • "If someone arbitrarily assigns that paper a price, without regard to what that paper represents, in the hopes of convincing someone else to pay a higher price in the future, then he is "speculating." Conversely, if he buys a stock realizing that it is much more than just a piece of paper and actually represents a legal claim on the firm's net assets, he is investing."

    I guess I'm just saying there is some gray area in between those two black and white thought processes. You can buy a stock based on what it represents without basing that purchase on book value. In that case, you believe the stock is undervalued based on earnings or cash flow. Just because you are not taking the balance sheet into account (let's say tangible book value is negative or immaterial), I don't think that means you are absolutely speculating. If the company isn't making money, or trades at 100x earnings, then you are, but you can find a stock trading with an 8 P/E, growing at 15% per year, and that can be considered value even with no book value. Some companies are just in service businesses without "real" assets.

    I think that is why most stocks are valued based on earnings or cash flow, not book value. Financials are valued on book value (banks, insurance companies, etc) because their main assets are liquid and are easily valued every day. Other than those sectors, I can't agree that ROE is a more important metric than P/E or EV/EBITDA.

    Thanks for the discussion, guys. Always interesting to see how others approach the markets. Take care.

    By Blogger Chad Brand, at 31 May, 2007 17:31  

  • I just discovered your blog and agreed with most of what you are writing. However, I think I lost you when you said: “I guess the bottom line is that ROE, not P/E is the most important ratio in stock analysis.”

    Perhaps you didn’t mean to be didactic but you can’t just look at either one of these measures in isolation. Clearly you have to consider the price of the stock. You can have a great ROE but if the price is too high it’s not worth buying. If you are going to focus on ROE then you should probably also look at the P/B ratio. All else being equal a higher ROE translates into a higher P/B ratio. Only problem with book value is that, like earnings, God only knows what’s in there – except it’s cumulative of all past sins.

    On the other hand, if you want to focus on earnings then you also need to focus on ROE because a low ROE could explain why the P/E ratio is so low. You don’t want to reinvest your capital in a low rate of return business.

    I consider myself a value investor and have always focused on both P/E and ROE.

    By Blogger glucido, at 28 August, 2007 19:06  

  • Chad,

    I dont agree (partially) with your point.

    There are lots of companies which is partially liquidating every year. (Yeah I am talking about Dividend)

    Lets think (for a time being) Future bacwards. If a company ABC stops giving dividend instead carried forward to next year, it will be shown up as increment in Book Value

    I think Dividend should be considered as Partial Liquidation.

    Again Dividend can be easily calculated & understood by any Invester and can not be maniuplated by any company


    By Blogger VISHNU, at 01 November, 2007 03:04  

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