Early in my ‘career’ as an investor and market commentator, I found myself mystified by many investing principles. But the one that got me thinking the most was the idea of intrinsic value or valuation more broadly.
Intrinsic value — sometimes called ‘IV’ in the industry — is the idea that an asset (a business, share, property, etc.) has a value — and that value can be different to the market price.
With that central tenet in hand, since the greats of Graham and Dodd in the early 20th century, investors of all stripes have sought better ways to find the most undervalued opportunities on the market they could find… before everyone else.
As a young professional, I spent much of my time working remotely for a company from my home office in Melbourne’s outer east. I was eager to read and learn anything and everything I could to understand how I might accurately calculate the IV of a stock, business or any asset that crosses my path.
Buffett, Munger, Lynch, Greenwald, Greenblatt… I was reading all the famed authors and investors in the hope of discovering the ‘holy grail’ of value investing. A Master’s of Applied Finance, Master’s of Financial Planning & CFA Level I promptly followed.
How Valuation Works
It didn’t take me long to discover the most important business valuation concept of all.
That model is what’s called a Discounted Cash Flow or DCF analysis. DCFs have been brought up a few times in our Australian Investors Podcast interviews.
The idea behind a DCF is that the value of any asset, such as a business, is equal to all cash flow you expect the asset to generate in the future. You then discount that cash back to today’s dollars.
Here’s what it would look like in a chart:
As you can see, it’s surprisingly simple. Not only that. It makes sense: find something that produces cash, forecast the cash flow, buy it for less than the total value of the cash.
We apply these principles in almost every walk of life, yet in investing it seems too hard for most investors to comprehend.
For example, imagine you’re a business owner and you’re about to employ a new staff member. Before you hire him or her, you might forecast (or guess!) that by taking on the employee your business will make $100,000 more each year.
If the prospective employee tells you ‘I want $125,000 plus Super’, you can say, ‘sorry, but you’re not worth that’ (as politely as possible).
The same concept is used in value investing but the tools to calculate the worth of an asset seem to be a little more technical (at least, that’s what the professionals would have us believe).
Why Valuation is Simple But Hard
Unfortunately, investing in public businesses (aka shares) can be more art than science. And that’s why investing can be hard.
Why is it more art than science?
You’ve probably heard me say before that investing returns are predicted by one formula:
Sharemarket returns = dividends received + earnings growth +- change in sentiment.
It’s a simple formula to understand, right?
You get dividends in your pocket and all else being equal, if the ‘sentiment’ in the market picks up, you expect to make money because investors are willing to pay more for the same investment.
For example, let’s say you have a company that does NOT pay a dividend but makes a profit of $1. Since it has no dividend, the returns from this stock will be predicted by the formula: return = profit growth +- change in sentiment.
Let’s imagine your company grows its profit by 10% (from $1 to $1.10).
To keep things simple, let’s also imagine that sentiment does NOT change.
In theory, you should make a 10% gain on your investment.
How does that work?
We can put our finger on sentiment by using a simple measure like the price-earnings ratio or ‘PE’.
As you likely know, the PE of a share is equal to share price / earnings.
If our example company had a PE of 10x it would mean the share price (P) was $10 because we know the earnings (E) were $1 ($10/$1 = 10x).
Going back a few steps, I said the company grows its earnings/profit by 10%.
In other words, the E in PE went up 10% from $1 to $1.10.
If we apply the PE ratio of 10x (a measure of sentiment) the share price will now be 10x $1.10 = $11.
Here’s the math again:
Return = $0 in dividends + $1 profit growth + no change in sentiment
Return = $1
What does it all mean, Basel?
Above, we assumed that the sentiment towards our company did not change despite its earnings/profit going up 10%.
However, as we know from news headlines, the market’s sentiment from one day/week/month to the next is always changing. It’s dynamic.
At any one time, the sharemarket is a boiling cauldron of psychology and biology, supply and demand, and hundreds of thousands of individuals with their own philosophy and time horizon.
Some folks believe they can make money by trading in and out of positions day-to-day, week-to-week or month-to-month. However, trying to predict with scientific precision what will happen today or tomorrow could be much harder than most people appreciate.
More than 50 years ago, Ben Graham famously said (I’m paraphrasing): ‘in the short term, the market is a voting machine (read sentiment). In the long run, it’s a weighing machine (read valuation)’.
Over the long run, when the effects of sentiment wear thin, the important factor for investors should be growth.
As it would seem however, many long-term investors still choose to focus the majority of their attention on things like dividend yields and price-earnings ratios, despite their transience.
In my mind, the most important thing for true long-term investors is understanding the growth (or lack thereof) of an asset. Because if investors can find a high quality business which is capable of compounding/growing at consistent rates for many years, the dividends and sentiment will eventually catch up (as Graham might say).
There’s so much more I can say on the topic of valuation, having studied and practiced it for many years. Unfortunately, this email is already longer than usual.
As you can imagine, valuation was a core topic in our value investing Workshops.
I had an absolute blast sharing my research tools, models and philosophy. Thanks to everyone who took part in our Workshops in Melbourne, Sydney & Brisbane. There was so much to cover but it was reassuring to receive wonderful feedback like this:
“Wish I had of found this course at the start of my investing journey!”
Until next time, happy investing.