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.