To clearly understand the concept of relative and absolute valuation it is necessary to give an example that in this case in particular is not related to companies or securities in themselves but to a less glamorous object like a cow.
A farmer called Roger has many ways of determining the right price when deciding whether to by cattle or not. Roger is a simple fellow, not familiar with the financial maxim that the value of any asset is the present value of the asset’s future cash flows. He does not see a cow as an asset when it really is.
Roger was thinking about buying a young cow, which he’d name Mary, after his first wife. He expected Mary to produce about 2,500 gallons of milk a year, which he’d sell for about $1.20 a gallon, bringing him about $3,000 in revenues a year. After paying taxes and veterinarian services, he expected to receive nearly $1,000 a year just from the milk.
Mary would give birth to a calf every year, which Roger would sell at a livestock auction for $500.
Roger believed that at the most, Mary would be worth about $8,000 to him. He figured that between milk ($1,000) and a calf ($500) she would generate about $1,500 of cash a year for five years — that is, $7,500. However, the $8,000 he’d receive over the five-year period would not be the same as $8,000 today — a lot of things could happen in five years. There is inflation and opportunity cost.
Roger's son-in-law, a banker, saw that Roger wanted to buy Mary. So he offered Roger to finance Mary’s future cash flows by giving Roger a lump sum today of $7,000. In exchange, he would have to agree to pay the bank $1,500 a year for five years and an additional $500 at the end of year five from selling Mary. In other words, the son-in-law’s bank would finance Mary’s purchase at 6 percent a year.
For Roger to accept, his son-in-law explained to him the following: If Roger could forecast Mary's cash flows with complete certainty, then he could accept the offer and buy Mary at the livestock auction for $7,000 at the most.
If Roger bought Mary for $7,000, he would be compensated for inflation and opportunity cost but would not be compensated for the extra risk. Roger's experience was telling him that he should at least demand double the riskless rate that his son-in-law offered him, and require a 12 percent rate of return for Mary’s risky cash flows. This would bring Mary’s fair value to about $5,700.
If Roger bought Mary for $5,700, the value of Mary’s cash flows discounted at 12 percent, he would be compensated for inflation, opportunity cost, and risks that arrive with owning a cow.
The problem with this entire situation is that Roger has several daughters' weddings to pay for and this has turned him into a cautious farmer. For any savvy investor, Roger would be considered a value investor. However, he feels is just common sense. He thought if he bought something at fair value then he had a little margin for being wrong. Even if his forecasts were right on the money, there were still many variables that he could not control or forecast.
Discounting Mary’s cash flows using the 12 percent risky rate provided Roger some cushion if things went wrong. The 6 percent risk premium provided a $1,300 risk premium buffer. However, if Mary was purchased at fair value ($5,700) and cash flows came in below Roger’s estimates, he would not be fully compensated for the risk taken.
However, he needed a margin of safety for two reasons:
- If things turned out as expected (or better), then he would have made extra return from buying Mary below her estimated fair value of $5,700.
- If Roger made a mistake in forecasting future cash flows, or some of the risks that he had no control over impacted the cash flows, he’d have a margin of safety to fall back on.
With these thoughts, Roger went to the livestock auction looking for his Mary. Despite his intention to purchase the cow, Roger did not buy Mary on the first day. The bidding for cows went too high — many sold above their intrinsic value.
In day two, Roger did not buy Mary either. The day was more productive than the day before. Roger decided to carry out analysis. Instead of becoming obsessed about prices, he did research on the cows available for sale. Research involved identifying the best of breed, which ones were more susceptible to sickness, and which had the potential to produce more milk.
The third day was Roger’s day — the day when he bought his Mary. Many disappointed farmers who had just bought cows at prices above their intrinsic values with a hope of selling them at a profit were selling them at any price just to recover some of their investment.
Roger found the right cow: the best of breed that met all Roger's requirements. The best part was that Roger bought the cow with a 25% margin of safety — he paid only $4,300.
Without giving it a second thought, Roger was using a discounted cash flow model to analyze the purchase. He estimated the drivers of value:
■The revenues: milk, calves, and beef she’ll produce over the years.
■The costs associated with taking care of his favorite cow, which had all the personality traits of his first wife.
■ Her longevity: The longer Mary can keep producing high-quality milk, the more valuable she becomes.
■ The external risk factors: the whims of consumer demand, taxes, political risks, regulation of the dairy industry, and so on.
Of course, Roger had other techniques to turn upon buying Mary. To him they were the shortcuts, his rule-of-thumb tools: the price divided by anything, where anything could be earnings, cash flow, revenues, gallons of milk, or anything else! They were relative valuation tools, as they established a relative value link between a price and a value creator.
Relative valuation tools provided a relative assessment for pricing value creators when considering Mary’s history or in relation to the valuation of other cows. Roger found that often ‘‘price to anything’’ measures were an adequate shortcut to figure out the appropriate price of a cow.
From his wealth of experience, Roger knew that at 3.8 times cash flows a typical two-year-old cow like Mary was fairly valued. A quick look at historical price-to-cash flows ratios confirmed that a cow of Mary’s stature on average changed hands at about four times cash flows. Also, over the previous five years, similar cows changed hands at as low as 2.7 times cash flows, and went as high as eight times. In Roger’s estimation, at eight times cash flows Mary would change hands at a higher value than the sum of all the cash flows she could possibly produce for her owner over her entire productive life: $8,000.
The price-to-cash flow ratio had its advantages: It quickly helped him to identify undervalued cows on the livestock auction. He objectively determined the required margin of safety for Mary — 25 percent — and figured that he wanted to buy it at about 2.9 times cash flows. Then he just waited for prices to drop and bought his Mary. The buy was not done at the lowest price, but he bought her at a significant discount to her intrinsic value.