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What is the Right Multiple to Pay for a Stock?

April 16, 2011 | About:
Geoff Gannon

Geoff Gannon

414 followers
Someone who reads my blog sent me this email:

I just came across your blog last night and i just finished reading the article how to value a business. You wrote... that means I appraise a stock’s earning power value as being worth (Cash - Debt) + (10 * EBIT) or (Cash - Debt) + (15 * Free Cash Flow)…my question is where do you come up with these figures 10 (for EBIT) or 15 (for FCF)? Does this apply to all businesses of any sort?

No. Those multiples doesn’t apply to all businesses.

I was just talking about businesses that are normally unlevered. So we're not talking about banks, insurers, railroads, utilities, etc. Those businesses are a little more complicated than a grocery store, a software company, an advertising agency, etc. So, let's put them aside.

The figures of 10 times EBIT and 15 times free cash flow are estimates of what the largest public companies normally trade for. If you go back to 1871 as Professor Shiller did and look at the S&P 500, it trades around 15 times the average (inflation adjusted) earnings of the last 10 years.

So, I'm talking about 10 times "normal" EBIT and 15 times "normal" free cash flow. Normal - like Warren Buffett said in this year’s letter to shareholders - means a general business climate better than 2010 but worse than 2005 or 2006.

In other words, the economy is still running a bit below normal right now. It was running a bit above normal in 2000. You kind of smooth that out as best you can. A good way to do that is look at average past earnings. Or, to use the free cash flow margin or return on capital over the last 10 years and apply it to today's current sales or capital base. Something like that. You don't just want to take last year's earnings. And you certainly don’t want to project next year’s earnings. Because that means you might be multiplying a peak year by 10 or 15 - which would be very bad if the peak is say 30% higher than "normal".

So, where do I get 10 times EBIT and 15 times free cash flow?

Well, Shiller found that 15 times past inflation adjusted earnings is normal for the market as a whole. Basically, Grantham and Hussman get the same answer in different ways.

That makes sense, because 15 times earnings is 6.67% (1/15 = 6.67%). I'd guess that's close to what the real return in stocks has been - so with 3% inflation and the market at 15 times earnings, you'd expect about 9.7% a year in total returns. Let's call it 10%. That's been possible because prices were at a certain level and inflation was at a certain level. If prices were normally higher at all times, returns would have to be lower.

Normal for the stock market has been a Shiller P/E of 15 times.

Why free cash flow instead of net income?

We don't have free cash flow data going more than a couple decades back. But I just want to make sure investors who read what I'm writing know to look for cash earnings instead of the kind of earnings railroads and cruise lines report. The depreciation expense at a railroad, utility, etc. is lower than their actual cash expenses. So, the "right" P/E ratio for a railroad might be closer to 10 times earnings than 15 times earnings. The right P/E ratio for an advertising agency might be more like 15 or 17 times earnings. The difference could be that big with some companies.

The amount of earnings turned into cash varies a lot by industry. So, I don't want anybody turning down an advertising agency with a P/E of 13 because that's higher than a railroad with a P/E of 10. In reality, the ad agency might be a little cheaper. Don't focus on free cash flow year-by-year. But over 10 years or something, free cash flow is what you want to look at. That's the only part of a company's earnings that can eventually be paid out as a dividend.

At the very least, you want to look at the historical relationship between net income and free cash flow. If a stock’s report net income always exceeds its free cash flow – that stock’s reported earnings deserve a lower multiple than if the reverse was true. Earnings that can’t be paid out in cash today are worth less than earnings that can be paid out in cash today.

The EBIT estimate is just a tax rate calculation.

Usually, at some point, you’ll want to evaluate a business separate from its debt structure. What is the underlying business worth? That's especially true when the amount of debt or net cash rises or falls over 10 years. Well, countries like the U.S. tax corporations around 35%. Or, I should say, that's what many companies I see actually pay. Some big multinationals pay less in U.S. taxes – but a big part of that is their refusal to bring earnings back to the United States. If you just look at small local companies in the U.S. they really do pay about 35% even if General Electric (GE) and Pfizer (PFE) don’t.

For example, Village Supermarket (VLGEA) runs grocery stores in New Jersey. It doesn’t get any earnings from overseas. And it does pay taxes in New Jersey. So, about 41% of its earnings go to taxes each year.

As you can see, 35% is just an estimate. But, it’s the best estimate we have when deciding how much of a public U.S. company’s EBIT will go towards paying the government.

Of course, a company’s tax rate will change depending on its mix of debt and equity. But, we don’t have to worry about that if we use enterprise value instead of market cap to judge the cheapness of a business.

Enterprise value looks at a company as if it had neither debt nor extra cash. In that case, the tax would be around 35%, because the company couldn't deduct any interest charges.

The formula is: Pre-Tax Earnings * (1-Tax Rate) = After-Tax Earnings.

In the U.S. that means: EBIT * (1-0.35).

And 15 * 0.65 = 9.75.

In other words, 15 times free cash flow is usually the same as just under 10 times EBIT.

The reason the two numbers don't match is that the company is using debt or paying more or less in taxes than is normal. A new owner could add debt or remove cash or do anything he wanted. So, he might not look at 15 times free cash flow the way you and I would as passive outside investors. He might look at 10 times EBIT. Normally, buyers of whole businesses look at EBIT or EBITDA. They look at some operating earnings or cash flow number. Not reported earnings.

I should point out that none of this means you should pay 10 times EBIT or 15 times free cash flow. It just means that you will likely do about as well or as badly as stocks generally do when you pay those kind of prices. Those are the kind of prices the S&P 500 often traded at in the past. That's what companies like JNJ and Microsoft often trade for.

Not always. Microsoft is cheaper than that right now. That’s a reminder that there’s no perfect multiple – either of free cash flow or EBIT – to use when valuing a business. What multiple you pay for Microsoft ultimately depends on what you think of Microsoft’s future. Right now, Mr. Market is thinking gloomy thoughts about Microsoft. That’s why the multiple on Microsoft is so low right now. Whether it’s the right multiple or the wrong multiple depends on how quickly Microsoft’s competitive moat disappears. If the moat is going to remain for many years, the stock is clearly cheap today. If the moat is going to vanish any day now, the stock might actually be too expensive.

That’s the way it works with every company. It’s not really about growth – or not only about growth – the way many models make it seem. A stock’s multiple has a lot to do with its competitive position. How certain are future earnings? Coke doesn’t trade for a high P/E ratio in normal times because it has great growth prospects. Coke usually trades for a high P/E ratio because it has a great brand. It has a wide moat.

When you’re looking at the overall stock market, none of this matters. The S&P 500 doesn’t have a moat. The S&P 500 isn’t above average or below average. It is average. So you don’t have to worry about those things when looking at the overall market. Something like the Shiller P/E ratio makes a lot of sense when looking at the S&P 500. It makes less sense when looking at Microsoft or Coke or Facebook.

Things are different when you’re looking at specific stocks.

You would need to make sure the business was of high quality and you would want to pay less for your stock than most people pay for the average stock. After all, why pick stocks if you only get the same prices everyone else pays through their mutual funds and index funds.

Ben Graham wanted a 33% margin of safety. In other words, he never wanted to pay more than $2 for something that was worth $3. Applying this rule to stocks generally, that would mean paying less than 7 times EBIT and less than 10 times free cash flow.

Again, we mean "normal" EBIT and free cash flow here. If the company's having an unusually good or bad year, you might need to adjust the number up or down a bit so it looks more like the company's normal performance over the last decade or so.

Unfortunately, stock prices aren't real low right now, so it's kind of hard to find large companies trading for less than 7 times normal EBIT and 10 times normal free cash flow.

Finally, I should say a bit about what “normal” means.

It’s easier to recognize “abnormal” earnings than normal earnings.

But there is one rule you can always use. To be normal, last year’s earnings absolutely must meet at least one of these three conditions:

1. Last year’s EBIT is less than 10-year average operating margin times current sales.

2. Last year’s EBIT is less than 10-year average return on invested tangible assets times this year’s invested tangible assets.

3. Last year’s EBIT is less than 10-year average EBIT.

Meeting one or – in theory – all of these rules doesn’t necessarily ensure that the P/E ratio you see for the stock reflects that stock’s normal earnings. But you have to be able to use one of these three measures to justify last year’s earnings or you need to throw out last year’s earnings for being abnormal.

Normal means the margins are normal, or the return on capital is normal, or the overall profit level is normal.

By far the most controversial measure is #3. Be careful using it. The only reason to use a long-term trailing average of actual EBIT or free cash flow instead of applying normal margins or returns on capital to today’s sales or assets is that the actual volume of business in the industry bounces around a lot.

As long as you know the company has maintained or grown its market share over the last decade, it may be helpful to look at a long-term average free cash flow or EBIT measure because you can’t predict what normal sales for the industry actually are.

Obviously, it’s better to avoid companies like that.

The more stable market share, sales, margins, and returns on capital are – the easier it is to evaluate a business.

Taking Microsoft as an example, it’s very hard for us to know exactly what Microsoft’s future will look like. But, it’s actually pretty easy to see what the company’s normal earnings are. The problem is not the business cycle. It’s technological change. If we knew technology wasn’t going to change, we could definitively say that Microsoft is cheap right now.

That’s different from a company like Posco (PKX). We aren’t as worried about technological change in that case. But we are very worried about what “normal” looks like in the steel business. It bounces around a lot. You can see that in Posco’s bouncy margins and bouncy capital spending. We need some way to smooth out that bounciness.

So we look at things like margins, returns on capital, and long-term average earnings to get some idea of what a smooth, “normal” earnings number would look like.

We can then compare that number to Posco’s enterprise value.

If we’re secure in our knowledge of what normal looks like – and with Posco you’ll never be completely secure – the right price is probably about 15 times free cash flow.

But there’s a lot of uncertainty built into steel. And even if we were pretty sure of our estimate, Ben Graham would say there’s no margin of safety unless we paid 10 times free cash flow instead of 15 times free cash flow.

Obviously, Ben Graham didn’t talk about free cash flow – the cash flow statement wasn’t standardized until his career was over. But the idea of paying no more than two-thirds of what a stock is worth applies equally to stocks bought for their earnings and cash flow as it does to stocks bought for their current assets.

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Geoff Gannon
Geoff Gannon


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Comments

graemew
Graemew - 3 years ago
Thanks for an interesting article! I have heard before that some very successful investors use this notiion of 15 times normalised free cash flow, when valuing a company. I find this hard to accept since I consider that it is not logical to use a standard multiple like this. The multiple should vary according to the amount and sustainablility of future growth, as best this can be estimated. Is there something wrong with my logic here?

Trustamind
Trustamind - 3 years ago
graemew,

I agree that future growth will affect the multiple. So will many other factors, such as market trend (bear market will see low multiple for sure), inflation (high inflation means low multiple), sentiment, etc. We can keep adding things and the list will never stop growing. One approach accepted by most value investors is to apply a "margin of safety". Say if the intrinsic multiple is 15, we will not buy if the multiple is above 15 x (1 - 40%) = 9, which means a 40% margin of safety. The point is once you have MOS built in, you don't need to worry about all the other factors. Hope this help.

Thanks.

Thanks for an interesting article! I have heard before that some very successful investors use this notiion of 15 times normalised free cash flow, when valuing a company. I find this hard to accept since I consider that it is not logical to use a standard multiple like this. The multiple should vary according to the amount and sustainablility of future growth, as best this can be estimated. Is there something wrong with my logic here?

jrossi
Jrossi - 3 years ago
So, how do you do the normal FCF calculation? Do you find FCF/share for each of the last 10 years, adjust each year for inflation, and then average them?
graemew
Graemew - 3 years ago
Trustamind, thanks for your ideas above. However I think it is first necessary to establish an appropriate multiple for a particular company before you establish what multiple would imply a margin of safety. A multiple of 9, for example would be expensive for a company with no expected growth in earnings over the next 10 years. Therefore I consider it illogical to value a company without first estimating future growth...unless you are merely calculating the value of the assets to see if the market cap is less than the market value of the assets of the company. In addition I don´t think market trend..e.g. a bear market should affect the calculation of intrinsic value (and an appropriate multiple), since you are only talking about psychological effects on the market, rather than a change in the real earnings power of the company.
Trustamind
Trustamind - 3 years ago
graemew,

I'm not against anyone who would like to spend more effort to have a better estimation on multiples or intrinsic value. It would be great if I have such capability to do this for every stock. I only tried to say that if it is too complicated to get a clean cut, we can still accept the not so perfect estimation and make good investment.

Also for bear market, how about I replace it with economy downturn? For sure economy downturn is not pure sentimental, and it will affect future growth of any company. And someone believes that bear market leads economy downturn for about 6 months. So it is actually an leading indicator.
jhodges72
Jhodges72 - 3 years ago
Buffett doesn't use EBIT.
jhodges72
Jhodges72 - 3 years ago
Shiller found 16.5 to be normal, not 15.
Trustamind
Trustamind - 3 years ago
jhodges72,

Yes! I think all those things, P/E, EV/EBIT, etc. are just different aspects of the same thing. If we are talking about a specific company, we may say P/E is better or EV/EBIT is better because of this company is doing this or that. But if we are talking in general, I think it is really hard to say which one is better.

Buffett doesn't use EBIT.
jhodges72
Jhodges72 - 3 years ago
Ratio investing, in my opinion, is a inaccurate process unless the true earnings of a business, which entails very detailed work, is taken into account. This information is almost always different than what is reported. The argument isn't that the Efficient Market Theory is incorrect. The generalized market has a very good idea how to value stocks based on "reported information". Where the inefficiencies of the EMT theory resides is that reported information is most often incorrect which often leads to incorrectly priced assets. Using a generalized P/E metric, for example, which is based on the "norm" will produce very abnormal valuations in regards to individual cases. When a company sells a building and reports their gain on that asset as revenue, that is information that must be known and deducted from reported earnings. When a reserve account that has always been operated at 5% of revenue but this year is lowered to 2% of revenue, and the excess reserve has been released into the revenue stream, such capital infusion into the revenue stream is deceptively increasing net income. Such an event must be recognized and deducted. Metric investing is not a sustainable proposition. It's virtually useless.
Trustamind
Trustamind - 3 years ago
I think everything I was trying to say can be summarized into just one sentence:

"It is better to be roughly right than precisely wrong"

=============

jhodges72,

I understand what's your point, but there is ways to deal with that. Before going into that, let me try to summarize what's in my mind. This could server as a framework of future discussion.

If we simplify the investment world as a two-dimensional world with one dimension being general vs. specific, and the other dimension being objective vs. subjective. All the value investors want to stay in the corner that is specific and objective. So we make sound (by being objective) and accurate (by being specific) investment decisions. The risk, at least it is a risk to me, is that when we are trying to be specific, it's hard to maintain objectiveness. For example, when I want to pay premium for growth on high-tech companies, is that because the growth is associated to the fundamental quality of high-tech companies, or I just feel good by reading a couple of rosy reports from big name research firms? Those research report may be far from objective because they may have ignored some "non-supporting" facts. If I really know the sector, industry, or company well, I could spend time to be specific and also objective. But still, it is always good to ask: How do I know!

So a practical approach is to start from the corner that is general and objective, and move towards the corner of specific and objective with baby steps, and always double check to ensure objectiveness. But the further you move, the more complicated it gets, and the more error you may make. Again, I'm not against anyone who would like to spend time and effort to proceed. I admire those people. But I only want to mention that there is ways to deal with that. That is the margin of safety (MOS) we talked about before. Value investor could still be general and objective, and make good investment with MOS.

So what MOS save value investors from:

1. Time and effort

2. Errors from being subjective

3. Errors from complexity

4. All other type of errors, such as management, economy, etc.
jhodges72
Jhodges72 - 3 years ago
"Value investor could still be general and objective, and make good investment with MOS."

I disagree. The current case of China MediaExpress (CCME) is an example. A "value trap" cannot be safeguarded with a Margin of Safety. Only indepth research can. That is why it is so important to work within your circle of competence to begin with. For example, I looked at CCME because many moons ago, I was a producer of a television company. I had and have extensive knowledge of the advertising world. Working within my circle of competence in regards to CCME allowed me to understand its business fully and it allowed me to recognize that it was a value trap with accounting red flags all over its financial statement. I avoided the company and saved a lot of money by doing so. Now, if you were to take their reported financial statement at face value, it looked like a tremendous value stock with a huge margin of safety available; on every metric there was. Today, the stock is halted and received a NASDAQ delisting notice. The probability of it going pink is very high. The probability that many "value investors" are going to lose a lot of money even higher.

For this exact reason, I make my case that ratio investing is useless. However, is it a starting point for screening purposes? Sure, but nothing more.
Trustamind
Trustamind - 3 years ago
I never touch China concept myself. It is outright deception. I think it's beyond the scope for constructive discussion.

If we are talking about corner cases, we can always find corner cases to counter almost any established theory. I have no argument on that.
jhodges72
Jhodges72 - 3 years ago
Although we hold the same outlook concerning Chinese stocks, there are many value investors who don't agree with us. In any event, I believe the definition of security analysis has not changed since Ben Graham described it.

"An investment operation is one in which , UPON THOROUGH ANAYSIS, promises safety of principle and an adequate return. Operations not meeting those requirements are speculative."

I don't believe Graham's definition of "thorough analysis" is the study of ratio's. Graham's P/E was always an adjusted one.
Trustamind
Trustamind - 3 years ago
I agree. (But I have some side thoughts. I'll talk about that at the end just for fun.)

P/E (or any single factor) should never be the reason to buy a stock. If an investor is capable, he's always encouraged to gain more knowledge and do more research. I just trying to say that everyone, expert or newbie, will reach a point when more research will cost more and benefit less. It could be the lack of knowledge, or uncertainty of future, whatever. To address all the risk that is not covered by his research, value investors apply MOS. And I would caution that more often than not, excessive research is bad because it may be based on subjective guesstimation and it may make the investor over confident.

Let's go back to Gannon's original post, it answers the question "what is the right multiple to pay for a stock". Supposedly an investor already knows the company has good financial condition, is growing, or doing stable business, earning consistent profit, or have a capable management team. He just want to know what's the price he should pay for it. The article doesn't try to answer "At what multiple a stock is a good investment". If this would be the question, my answer would be, no such multiple exists. Bankrupt companies will have 0 multiple, but they never are good investment (I know there are corner cases, when the owners of the bankrupt companies have right to own the stock of the new company. But I think my statement is, again, "roughly right than precisely wrong")

Then here is my side thought. Just for fun. I think although every individual should be objective when valuing a company, in fact the valuation is collectively subjective. It is collectively subjective because the market is a voting machine (in short term, of course). With this in mind, should a value investor always try to use the most popular ratio, i.e., P/E, when he try to value a company? At least to start with?
jhodges72
Jhodges72 - 3 years ago
I stopped at your first paragraph only due to lack of time. I'll address the rest at a later time.

"excessive research is bad because it may be based on subjective guesstimation and it may make the investor overconfident."

I disagree on this grounds. I am a very concentrated investor. I believe in Buffett's less than 6 theory. I hold on average 3 stocks. If I'm not extremely confident, I've got a problem. The only way to build my confidence is through research. Of course, it all depends on what kind of research is performed. Nonetheless, I perform it exhaustively. Since I believe diversification has an adverse affect due to the inability to keep up with all the information necessary to properly manage a large portfolio of stocks, it is important that I know as much about the operation as management does or I'm not interested in dedicating my capital towards that business.
Trustamind
Trustamind - 3 years ago
I couldn't comment on your personal investment method. As long as you are benefited from every bit of your exhaustive research, I won't think it's excessive.

I do want to say one thing about diversification. Sure diversification is not designed for lazy investors as an excuse for flawed decisions. But to us human begin there are things we couldn't forecast or control. Diversification is designed for that.
jhodges72
Jhodges72 - 3 years ago
I have nothing against diversification. It's just not for me. Ben Graham preached it while Warren Buffett preached concentration. I've done both and prefer a concentrated portfolio. 30 stocks were too much for me to keep up with. 175 pages on average in a 10-K. It was nearly impossible to make an informed decision concerning those 30 stocks for me.
jhodges72
Jhodges72 - 3 years ago
Picking up where we left off. You made the comment that bankruptcies are never good investments. It's interesting that you say that in our discussion since bankruptcy cases are my primary focus. I made over 250% this year alone on my portfolio in a bankruptcy case. Have been involved in 4 of them in the last 3 years. Have made over 100% in each one. They are fabulous investments for those that have knowledge of them.

Very little information exists with bankruptcy cases. You're not going to find information readily available. You have to dig and know where to dig. That is the perfect swimming grounds for a value investor. The less information the general public has knowledge of, the better your chances are.Many bankruptcies are cigar butt style investments. One good puff is usually left. If their isn't, obviously you don't invest.

In regards to a popular ratio in order to come to a conclusion about market participants, I believe a cyclically adjusted P/E of what the company has traded for in the past during good years and bad would deliver fair results if the company was properly capitalized and experiencing sustainable growth over a period of time, i.e. 4 years.

An average investor that has average knowledge of valuation would probably do decently, at least better than a money market and possibly the overall market with that kind of approach. For that matter, a magic formula would be appropriate. But for someone who's interested in more, I just don't see the relevance of a ratio such as the P/E, other than for the initial screening process. Ben Graham explained how it's possible for a company with a P/E of 25 was actually much cheaper than a company with a P/E of 7 was much better than I could. Unfortunately, there's not enough space here. His indepth study is in Security Analysis. You may or may not have read it. It's interesting nonetheless.

At least Gannon uses a cyclically adjusted P/E, or at least I got the impression that he did by quoting Shiller. That's better than most analysts use. Its just not for me and I argue its relevance especially when it is derived from what the general market thinks the security is worth divided by GAAP earnings which allow for items that can either inflate or deflate the true earnings of a business.
Trustamind
Trustamind - 3 years ago
There is ways to achieve diversification without dealing with too many individual stocks. One can invest in ETFs. Actually I should thank you for this. I got this idea following our discussion on diversification. I have developed a fundamental ranking system. I back tested it over 3000 stocks in the past 10 years and the data shows that higher rank stocks almost always outperform lower rank stocks in a holding period from 1 week to 6 weeks. However there are two problems with it: liquidity and volatility. Some stocks have low trading volume so one couldn't put too much money into it without significantly moving the price. Although in average the performance is good, a single stock may see big deviation from the average. I was struggling with these two problems for a couple of days without any good solution. Then we have this discussion and we talked about diversification. Suddenly this idea pops up to me: I can use the ranking system to rank ETFs, the rank of each ETF is the weighted average of the ranks of the stocks in its portfolio. And ETF hits two birds with one stone. It is naturally diversified (so less volatility), and it has much better liquidity. I've crunched numbers and the result looks good, at least I'm satisfied with it. I'll post that in my own thread about the fundamental ranking system. You are invited to check it out if interested.

Now back to other issues. I was actually a little bit frustrated when you were using CCME as an examples. Now I fully understand why you always talk about things that is beyond my imagination. Your investment strategies ARE beyond conventional wisdom. Or maybe a successful value investor has to be beyond conventional wisdom? And it was me the only abnormal one here? Yes Gannon quoted Shiller P/E and he suggested me to take a look at it. To be honest, I'm only using 1 year P/E. It is popular and my goal is for short term gain so I think I should focus on popular ratios. If you ever looked at my thread on fundamental ranking, you could see that statistically there is strong link between short term return and the fundamental quality of a stock, though I didn't mention all the indicators I use are based on one year's data.

I believe you are a successful investor and I admire your capability of carrying it out, though we couldn't agree on many things and I couldn't imagine I would ever try to mimic what you are doing. I think it all boils down to different personality. Good to know you here and I'm glad we had this discussion. I owe the ETF idea to you.
jhodges72
Jhodges72 - 3 years ago
1. ETF's don't interest me. It is much different than diversifying between 30 or even 100 stocks. You're purchasing 100 - 500, or more or less, stocks that you mostly likely don't even know what they are. In my opinion it is nothing more than throwing darts at random targets.

2. I don't understand your definition of "lower rank stocks". Could you elaborate? What makes a stock out-rank another?

3. Your idea that because an ETF is more diversified that it is less volatile unfortunately is a blatant flawed logic. It uses circular reasoning to produce its claim. There have been countless study's, especially by Warren Buffett, and there's no need for me to elaborate here.

4. Define "conventional wisdom". I don't know what that is since I only possess and am aware of the wisdom, if any, that I possess and of things that make practical sense to me. Purchasing an asset for $0.50 that has $1 worth of value, regardless of whether others see that value, makes sense to me. Purchasing a basket of 99 other stocks in hopes that somehow it will decrease the risk of my ownership in that stock doesn't.

5. You mention you use 1 year P/E and that it is popular. That is another use of circular reasoning. An example of circular reasoning in case you're unfamiliar with the term: "many people, especially analysts, use a one year P/E ratio when deciding the legitimacy of an investment proposition, therefore, it must be a good indicator." Most people lose money in the market too. Should you start losing money in the market just because the majority does?

In closing, Benjamin Graham put it best when he said: "You're neither right nor wrong because other people agree with you. You're right because your facts are right and your reasoning is right - and that's the only thing that makes you right. And if your facts and reasoning are right, you don't have to worry about anybody else."

I would caution that if you find yourself in agreement with the majority - most likely somewhere in the future your investment performance will start to mimic those you find yourself in a agreement with.

For example, you mentioned earlier that you don't see the relevance investing in bankruptcy cases. Warren Buffett, as noted by Prof. Bruce Greenwald recently, states that his favorite investor today is Seth Klarman. Seth's primary focus is to invest in distressed assets (bankruptcies). It's practically all he does. I'd start there if you ever decide to not follow the majority. Best of luck and nice meeting you as well.
Trustamind
Trustamind - 3 years ago
For 2, please spend 5 min to read it here: http://www.gurufocus.com/forum/read.php?2,128644

And I'm not following the majority, I'm taking advantage of it. Your logic is fact = right = profit, and non-fact = wrong = loss. I'm OK with the first part, that part that fact = right and non-fact = wrong. But I just want to point out that more often than not, right<> profit and wrong<> loss. If you couldn't understand it, it's just nonsense to you. And I don't think understanding it will make any good to you as you already have your own successful investment methods.
jhodges72
Jhodges72 - 3 years ago
I read your article and don't understand it any better than before. You list three criteria:

1. Valuation

2. Financial Condition

3. Return on Capital

With the exception of #3, 1 & 2 are subjective according to who is doing the work. The way you value a business, we've established, is much different than how I value a business. Conversely, the criteria for financial condition is a vague term that can describe many factors; one such factor being the leverage ratio of the firm. Concerning the latter point, there are various degrees of comfortability regarding leverage.

I'm assuming you're trying to replicate a scoring system similar to the Piotroski F-score. I'm not opposed to the idea, but according to your article - your definition is vague thus far.
Trustamind
Trustamind - 3 years ago
Yes and sorry I couldn't elaborate anymore. I keep it vague intentionally. And yes you can call it a scoring system while I call it a ranking system. The name is not important. The system is not based on fact, it is based on behavior, i.e., it tries to chase what the market would think the most important and make profit in short period. So I think I couldn't afford to reveal the formulas, because behavior, not like fact, does evolve over time, and it does respond to new input.

I shall admit that I'm from the opposite side. I began as a trader, though an amateur. I spend time to study the structure and the behavior of the market. But then I learned that one couldn't make big profit by only knowing structure and behavior. The market has something else in its mind, and lately I start to realize it is "value". It may not be the true value in the mind of a successful value investor, but that would be OK. As long as the market chases it, it might be a good idea to chase it in short term. That's how I come up with this ranking system. Just a little bit background. Hopefully you are not bored by this.
jhodges72
Jhodges72 - 3 years ago
Not bored at all but at the same time don't understand the point. If you're not willing to share the formula, then only you can understand it. Therefore, what's the point of making it public? In any event, good luck.
Trustamind
Trustamind - 3 years ago
I think the value is not in the formulas but in the concept. People who are interested may come up with their own way to chase the "value" in the market's mind. I just want to show that it might be something worth a try, and I provided data and analysis to support it. Just like you've showed me bankrupt company might be good investment. Maybe I'd try it sometime in future. Thanks a lot for that. And good luck to you, too.
jhodges72
Jhodges72 - 3 years ago
I hate to disagree on nearly every level with you so I hope you don't take it personally but the concept has been around for many years. Therefore, the reliability of the concept comes down to what it's backed by - which is the formula itself. I don't understand the secrecy of it since I know of no new valuation technique that exists today. Even Buffett reveals his formula's in his annual reports. Formula's are best left for public scrutiny. Such scrutiny only makes for a more intelligent person because one is challenged to defend their position using reasoning. If one cannot successfully do that, he must second guess his reasoning. It is for this reason candidates for public office must debate their issues in a public forum; so that they will stand the test. In any event, all the best.
Trustamind
Trustamind - 3 years ago
Not a problem at all. Revealing the formulas has at least three effects. You've discussed one. The other two are: to invite followers, and to invite competitors. In some sense followers are competitors, but they have different functions. In the world of trading, followers help you to mark up the price, while competitors squeeze out your profit margin. I'd like to have followers but not competitors. So I think the best way to do is, for a specific company, reveals only the formulas that is most important to value that company. Most brand name research firms are doing this. I think Buffet is doing similar things, more or less. But to reveal the whole package? It's too dangerous to me.
jhodges72
Jhodges72 - 3 years ago
Security Analysis was written in 1934, some (77) years ago. There are no more competition in the value investing/fundamental world today than there was then. If competition was a concern, Greenblatt wouldn't have published his formula which he still uses today with success. Not only did he publish his formula, he created a fund that exclusively uses the formula. Not only did he reveal his formula, but he told people that they can invest their money with him, pay him a commission, and he's going to use the same formula to invest their money and charge them a commission for doing so - as the freely available metric he published. Guess what happened? People, knowing this information, still invest their money in that fund.

I'm left with the alternative: that you are unable to rationalize your formula against scrutiny and for that reason have chosen the path of secrecy. Regardless, I have other interests to tend to today. Take care.
Trustamind
Trustamind - 3 years ago
Yes, let's stop here. Nice discussion. And Happy Easter!

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