The Art of Stock Valuation

When you purchase shares in a company, how do you know that the price you are paying is a good price? When you sell, how do you know if the sales price is a good price?

To answer these questions you have to be able to estimate intrinsic value. Intrinsic value is the underlying real value of a share in a company. It doesn’t necessarily equate to the current stock price, although the current stock price is frequently (but not always) close to the intrinsic value.

The most widespread method used to determine intrinsic value is the discounted cash flow (DCF) method as put forth by John Burr Williams in the 1930s in his book, The Theory of Investment Value. Williams defined intrinsic value as follows:

“The value of any stock, bond or business today is determined by the cash inflows and outflows discounted at an appropriate interest rate that can be expected to occur during the remaining life of the asset.”

A bond can be valued with precision using the above method because most bonds are contractually required to pay a certain percentage of the face value of the bond each year for a specified period of years.

Seth Klarman (a highly successful investor who founded the Boston based Baupost Group) states in his book, Margin of Safety:

“Stocks, for example, have no maturity date or price. Moreover, while the value of a stock is ultimately tied to the performance of the underlying business, the potential profit from owning a stock is much more ambiguous. Specifically, the owner of a stock does not receive the cash flows from a business; he or she profits from appreciation in the share price, presumably as the market incorporates fundamental business developments into that price.

Although some businesses are more stable than others and therefore more predictable, estimating future cash flow for a business is usually a guessing game.

The financial markets are far too complex to be incorporated into a formula. Moreover, if any successful investment formula could be devised, it would be exploited by those who possessed it until competition eliminated the excess profits. The quest for a formula that worked would then begin anew.”

And that in a nutshell is the problem with the DCF method: It requires the forecasting of cash flows for years into the future and this simply cannot be done with a high level of accuracy. Because of this, most DCF valuations are very limited in their usefulness.

Another funds manager, David Dreman, has shown that forecasting by analysts is generally poor and certainly not precise enough to use in a DCF model. In his book, Contrarian Investment Strategies: The Next Generation, Dreman states:

“Most current security analysis requires a precision in analysts’ estimates that is impossible to provide. Avoid methods that demand this level of accuracy.

There are no highly predictable industries in which you can count on analysts’ forecasts. Relying on these estimates will lead to trouble.

Many pros believe that their own analysis is different. They themselves will hit the mark time and again with pinpoint accuracy. If they happen to miss, why it was a simple slip, or else the company misled them. More thorough research would have prevented the error. Next time it won’t happen.”

What most of the “pros” actually do is make a naïve extrapolation of recent earnings into the distant future (usually 10 years) and come up with a share value. It should be noted that even relatively small differences in the forecast results can result in significant differences in the valuation that is arrived at.

In my opinion, rather than messing around with highly imprecise DCF models, you would be much better off taking the advice of billionaire Kerr Neilson:

“When all the numbers and discernable facts point to a company being abnormally cheap using 20 to 30 year relationships of price to book, enterprise value to sales and understanding of the company’s inherent cash generating capacity, the shares have a high probability of making you a handsome return.”

I’ll give you two real life example of Kerr Neilson’s above advice.

During the period 2005-2007, Caltex traded at average prices of around twice book value. Looking at Caltex’s historical price to book value would have informed any potential investor that Caltex was very much over-priced at around twice book value. History showed that a fair price was approximately book value (or may be slightly more).

Analysts and brokers attempting to value Caltex using the DCF model were quite prepared to pay twice book value because they had incorrectly forecast the cash flows and therefore their models justified prices of $20 per share or more.

Caltex was included in The Stock Scribe portfolio at $6.18 because:

1. That price represents a very significant discount to its book value;

2. The company has low debt levels in relation to its tangible equity;

3. It pays an attractive fully franked dividend;

4. It produces a product which is absolutely vital to all of us;

5. It’s a large company with a long history (having listed on the ASX in 1980).

The second example is the banks. During 2006 to early 2008, the big four banks were all trading at material premiums to their long-term price to book values. Any potential investor who studied this one statistic would have known that the prices that these banks sold for during this period were too high.

As a shareholder in a few banks, I was happy to sell at the then prevailing prices (my best sale was NAB at $41.98). Analysts using DCF models and naïve extrapolations of the very recent past found justification for paying $50 or more for CBA or $40 or more for NAB, but I couldn’t.

Selecting stocks based on historically low price-earnings ratios, price to book values, high dividend yields, low debt etc, does not mean that you are going to automatically make a fortune.

Once you have selected stocks using these sorts of screens, it then requires very good judgement as to whether you make an investment or not - and that is where many investors will fall down. The screening process is relatively straight forward, but the next decision (to buy or hold off) is much harder and there is simply no substitute for experience and plain good judgement.