Why Some Investors Fail -- Worms!
publication date: Apr 2, 2018
author/source: Brian Nelson, CFA
Image Source: crabchick
Intrinsic value represents the conclusion to any and all stock research: What is the company worth? DCF valuation captures the expectations of a firm’s competitive advantages, growth prospects, strategic endeavors, and any other qualitative factor. No other process does this. Putting to numbers a plethora of advanced fundamental items in arriving at a fair value estimate is the cornerstone--and the most critical component--of any stock research analysis. Without an in-depth intrinsic-value assessment, research is but a story that has no ending.
-- Brian Nelson, President, Valuentum Securities, 2011 slide deck
By Brian Nelson, CFA
A lot of investors may not apply valuation techniques in earnest, and this may not entirely be their fault. Many don't have the opportunity to be exposed to the discounted cash-flow process and learn how it is interrelated to price-observed quantitative methods in order to separate the concepts of price versus value, "The Tragedy of Quantitative Finance (2018)." To these market participants, multiples are a part of valuation, and valuation is just one investment consideration among hundreds.
For example, investors might say a stock is trading at 10 times EBITDA or that a stock is trading at 10 times earnings, but the reality is that these quoted measures offer little information about whether a company is undervalued or overvalued, or fairly valued. These measures can be good or bad. For example, 10 times EBITDA can be good for a company truly worth 20 times EBITDA and bad for a company worth 5 times EBITDA. And what about those earnings numbers? Are they non-GAAP? Are they the forward 12-month projection, or are they trailing numbers? And what if the company truly is fairly valued at 10 times earnings because it has a mountain of net debt on the balance sheet and growth prospects are grim?
Because of these questions and more, our team rigorously calculates the intrinsic value of every company in our coverage universe through the lens of a discounted cash-flow (DCF) model. The DCF framework is the only one that applies intensively and exclusively to each specific company that one is trying to value. That, itself, is invaluable and makes the DCF, in our view, a much better approach than other valuation exercises, including relative assessments that apply multiple analysis. On our website, we provide fair value estimates and fair value ranges for the vast number of companies in our coverage universe. They can be found here or at the top of each company's 16-page report.
But Why Do We Do This?
Let’s answer the question of why we focus so much on valuation by starting with a simple example.
You have four buckets: the first is filled with $100 worth of ice, the second is filled with $100 worth of worms, the third is filled with $100 worth of shampoo, and the fourth is filled with $100 worth of water. Which one is worth more, assuming each bucket is identical?
I have to say that a large percentage of investors would say that each bucket is worth the same. This isn’t a trick question. We’re hoping you’d say they are worth the same.
No matter how cold the ice is, or how good the worms can be used to catch fish, or how refreshing the shampoo is, or how thirst-quenching the water might be, the buckets still are worth the same. We’ve already determined the value of these buckets based on their respective intrinsic qualities ($100), and no matter how well one talks up the attributes of each, the value is not going to change.
But what does this example have to do with investing? Well, when it comes to investing, the ability sometimes to reason through comparisons like this, and the application of common sense to answer obvious questions like this often breaks down.
Why? Because investors start focusing and talking about the composition of a company’s value, instead of focusing on the firm’s value itself. Think of value as what something is worth because of its qualities (future free cash flows), not in addition to its qualities. Value isn't an investment consideration -- it often is THE investment consideration.
Let’s now try this example for illustration.
You have four companies. One continues to exceed earnings estimates, but its discounted future free cash flows suggest it is worth $70. Warren Buffett classifies the second company as having an ultra-wide economic moat, but its discounted future free cash flows suggest it is worth $70. The third company has an awesome chart, but its discounted free cash flows suggest it is worth $70. And the fourth company pays a hefty dividend, but its shares, too, are worth $70 each.
Which company is more valuable?
One might start hearing comments from "talking heads on TV" that the company that exceeds earnings estimates is the better idea, or you’ll hear others say that Warren Buffett’s economic moat makes the second pick better. There will be a third group that says the chart is all that matters, and the fourth group might not even consider the first three companies because those companies don’t pay a dividend!
Can you start to see how investors get confused this day and age? The whole ability to compare stocks somehow breaks down when they starting talking about them.
No matter how wide Warren Buffett thinks a company’s economic moat may be or how frequently the company has beaten earnings estimates or how fancy the chart looks or how high the dividend payment is, each company in the above example is still worth $70. The composition of the value is not a reason to own a company. The value of a company is THE reason to own it.
Getting A Bargain For Shares
Any day of the week, investors should prefer paying less than the present value of a company’s future free cash flows for that company (the bigger the discount the better), adjusted for balance sheet considerations. Notice how I didn’t say anything with respect to earnings estimates, valuation multiples, or Warren Buffett’s economic moat.
After all, how can one pay less than the value of ‘exceeding earnings estimates’ or less than the value of an ‘economic moat?’ How can one determine the value based on a chart? At times, market news sometimes just doesn’t make any sense. Earnings, competitive advantages, etc. are just factors that roll up to calculate the intrinsic value of a company, but the intrinsic value estimate is just that -- what a company is worth. It is the answer that investors should seek.
The value of a company is not a consideration to own a company; it is THE consideration. It embodies a company’s expected growth rate, its competitive prowess, and every other intrinsic factor. Discounted cash-flow valuation analysis is not a robotic output, or a grouping of financial metrics, but the process represents and embeds the conclusion to any and all fundamental analysis. It is not missing something -- it does not need more. It is the answer, the conclusion, the result of any and all research.
It's Okay to Debate Components of Value!
Now that said, of course it’s fine to talk about the qualities of ice, worms, shampoo and water (as in the above example), but at the end of the day, the only thing that really should matter, in our view, is what something is worth (what does it weigh). Legendary investor Benjamin Graham was well-known for calling the market a weighing machine in the long run, and to a large extent, the value (the weight) of a firm is what he was referring to in this particular instance.
Let's put it this way. If Benjamin Graham or Warren Buffett, two of the most famed value investors in history, could buy a "no-moat" stock for pennies on the $1, they’d likely do it, even if the company's competitive advantages were/are fleeting. After all, Buffett did do it with US Airways (LCC), arguably a no-moat equity, some time ago. The late Graham and his protégé Buffett focused/focus on price versus value. The point is not to let the underlying investment considerations such as a competitive-advantage evaluation complicate the final valuation assessment, which includes the underlying investment considerations already. It's price versus value that matters.
Don't get us wrong, however. Understanding business models is very important. After all, with a deep understanding of the risks of mREITs (mortgage REITs), we warned many Valuentum readers against capital erosion on American Capital Agency (AGNC) and other highly-leveraged mREITs both at the top in September 2012 (here) and right before the subsequent collapse (here). We also can't forget about how we warned against the risky business models and the collapse in shares of Kinder Morgan (KMI), Stonemor (STON), SeaDrill (SDRL), and so many others, including many master limited partnerships. Business model analysis is important, but valuation already includes the business-model assessment -- and ultimately tends to be the magnet for prices.
Humbly, we often wonder if investors that follow earnings estimates actually think the best companies of all time always beat estimates every quarter? These investors must know that there is something else supporting/driving the stock -- that is, its valuation. For the pure technicians, we humbly ask what happens when a chart rolls over? Is the company then doomed forever? Of course not. At Valuentum, we love combining valuation and technical/momentum indicators in the stock-selection process, the Valuentum Buying Index, but the application of the discounted cash flow model that results in intrinsic value estimation is the first component of the index.
Let's look at the inaugural Best Ideas Newsletter portfolio, released July 2011 here (pdf). At the time, the long idea considerations were Apple (AAPL), Altria (MO), Ancestry.com (which was bought out), Astronics (ATRO), Buffalo Wild Wings (which was bought out), Collective Brands (which was bought out), EDAC Tech (which was bought out), Precision Castparts (which was bought out), and Republic Services (RSG). The July 2011 edition that had the simulated Best Ideas Newsletter portfolio documented within it was certainly a valuable edition!
When you read our research and analysis, please understand we’re not just providing financial metrics. Valuentum is striving to provide an answer to the most important question in investing: what is a company worth? Though there are varying opinions about which underlying factor is the most important investment consideration, at the end of the day, the process of valuation collects every investment consideration to provide a conclusion. It is the answer after all other considerations, the final outcome of analysis. It is why we say that investors that don't pay attention to valuation may be doomed to fail...eventually. Not seeking valuation is not seeking the answer.
A previous version of this article appeared on Valuentum's website August 2013.