When I started investing my initial thoughts were aligned with “Greater fool theory“ which is to buy stocks hoping that someone else will pay a higher price for it, which was a very naïve and absurd way to reason, I was holding this type of belief for a long time which I thought dictated the value of a company.
There will be evidences that always challenge your beliefs in the market and same way my beliefs were challenged when I experienced a market crash, Stocks I bought based on “Greater fool theory” stopped working because others were not interested to buy stocks I held, which made me challenge my views on what dictates the value of a stock or a company.
After doing a bit of research I landed on my next hypothesis on value which is the P/E ratio. I started buying companies based on P/E ratio and my reasoning was to buy a low p/e which is having a good margin of safety and sell at a higher p/e which means the value and price gap has narrowed, but soon this hypothesis too was not working because p/e ratio is not an accurate measure of value rather it’s a function of value. I did not understand the cyclicality of businesses and why certain companies were assigned high p/e and few companies lower P/e and cyclical companies had very high p/e when earnings cycle was down.
Based on the above hypothesis I felt paying a high p/e for any company is worthless and only to buy low p/e stocks, I underestimated the growth built into the high p/e stocks and the value of franchise or what warren Buffett calls the “Moat“, I realized relying on P/e isn’t a good measure to find the value of a company.
I again began to search for what’s a better way to find the value of a company, my next hypothesis was on ratios like EV : EBIDTA. I compared companies in same industries without understanding the business model and not understanding why some companies in same industry commanded a premium while others were not ? The answer was evident later, premium companies always had a competitive edge over the other companies in the same industry, but I failed short in coming up with my ever curious question of what’s value of a company ?
My next hypothesis - Earnings per share, I read brokerage analysts reports and most of the reports ascribed EPS as a value metric ( EPS is earnings per share calculated by profit after tax / No of outstanding shares ) most companies with predictable and consistent earnings had a growing stock price and in some cases the returns were multi fold, so I thought I found out the holy grail of valuing a company which is earnings per share. So I started to invest in companies with predictable earnings, my value assumption was if company X earns 10 Rs per share this year and if it earns 12 in earnings next year than my value would be to just assign a p/e multiple to eps and derive value in this case ( EPS = 10 and P/E of 20 = Stock price 200, In year 2 Value would be EPS 12 and P/e 20 = Stock price = 240 ). This type of assumptions were working well until a few companies which had grown earnings but the stock price did not reflect the same, and also were re rated lower but the markets, that led me to further question this approach and it’s validity.
There are 2 main reasons why EPS is not a reliable Measure to value a company. 1. Earnings per Share doesn’t account for capital re-investments into the business, every business requires capital to grow and maintain its existing business, so earnings per share shows what the company earns in that particular year, but It doesn’t take into account if a company is able to produce cash flows to meet its capital reinvestments to maintain the business.
2. Earnings per share doesn’t take into account maintenance and working capital reinvestment. Capital intensive business requires high capital every year to maintain its business Ex; Cement industry, Commodity businesses require high working capital which isn’t captured in Earnings per share.
Finally with all these hypothesis not providing a reliable measure of value what else can explain value of a company ? I looked into how investors approached this problem. I read Warren Buffett, Professor Bruce Greenwald, Benjamin Graham and Michael Mauboussin and after synthesizing all the teachings of these investors I arrived at 3 approaches that explain value of a company.
1. Liquidation value method - This is also called as the Cigar butt method, Finding companies that are trading at a value that’s lower than the liquidation value. What would the investors of a company receive when the company is liquidated ?
Assume I invested in company X which has 2000 Crs cash in its balance sheet after adjusting for debt and all other contingencies and the company is now trading at 1000 Crs market cap, if the company is liquidated than i would receive more than what I have invested. This is how we approach a company in the liquidation method, Other approaches are using Graham’s Net nets companies that sell below its working capital and have a less P/b and P/e.
2. Cost replacement method - Cost replacement method is easy to calculate in commodity companies and old economy stocks. Let’s assume a Steel company is trading in the market at value of X and the cost to build a similar new company is higher than X than the company is said to be trading below its cost replacement method. Once you find out such opportunities which are trading below the value to rebuild a new one or another method is what a private buyer will pay for the company ?
Ex - In March 2020 SAIL was trading at 28 per share which by cost replacement method is way below the original cost of the whole company. The book value at the time was at 95 Which means I’m buying one rupee worth for 30 paisa, currently the stock is trading at 100 / Share.
There are high chances that a rational private buyer would pay more than 30 per share for sail. its difficult to calculate replacement cost in Franchise businesses like HUL or Nestle.
3. Owners earnings or Intrinsic value method - This is Warren Buffett's method to calculate value of a company and my approach to investing. There are many approaches based on this intrinsic value, but I will discuss the one which Buffett has mentioned.
This method is useful for companies with predictable cash flows and earnings. You have to know the company and it’s future economics to calculate intrinsic value based on this approach.
Owners earnings = PBT + Non cash charges - Depreciation - Capital reinvestment - Working capital investments
or
another name for this method could be called Free cash flows, Free cash flows are calculated taking into account after all adjustments for capital reinvestments.
True value of the company lies in how much cash can owners take out of the business after reinvesting for regular business to carry on. Every company requires cash to run its business, but good businesses are the ones that consumes less cash to grow, the gruesome businesses are the ones that consumes too much cash leaving no cash for owners to take out of the business.
The above is the first part of the equation, the second important one is to calculate what will be the business worth in 3 or 5 years in the future, To calculate that you have to understand the business and the dynamics. After which we assign a growth rate to the growing owners earnings and discount them back to present value.
Ex - Assume company X’s owners earnings in 2020 is 100, after making a few assumptions of the business I come with a owners earnings of 200 in next 5 years, which is a 15% CAGR. I need to know if I can buy the company now, So I discount the 200 to present value ( based on discount rates as per your assumption, Mostly RF risk free rate + your additional risk premium for investing in equity) assume my present value comes to 120, If the stock is trading at a steep discount from 120 maybe around 80 or 70 ( available with high margin of safety ) the stock is trading below the value. This is when the Price Vs value gap exists. As investors we need to anchor on Value of a company and not price.
All the methods discussed above has limitations, You cannot have used any of the above method to invest in Amazon or Tesla because they were not having positive earnings and nor the cash flows in the early days. We would have missed the wave completely.
As investors we are always biased and one such bias is “ Physics Envy” where we want precision estimates in financial world like in physics or science, due to complexity and human nature involved in finance we cannot arrive at a precision method to value stocks, but these can be used as guidelines. I myself don’t rely too much on these precision, I have a very flexible approach, in some cases even intuition has worked well for me.
Do your research and homework, although these methods won’t guarantee lasting success, failure is guaranteed if you don’t follow an approach that suits you, remember everything is driven by tail events, my success rate is 60% which means I fail 40% of the time. Nothing is certain is a binding principle.
Adapt and evolve !
Thanks for reading.