· Valuation: Measuring and Managing the Value of Companies (McKinsey)
· Value Investing: From Graham to Buffett and Beyond (by Bruce Greenwald)
I’m not going to give a review on which books are best. Instead, I’m going to talk about a more important topic:
Why is “what valuation method should I use?” by far the most frequent question I get asked?
It’s not the most important question you can ask about investing. I can think of tons of better questions:
· What does it take to be a good value investor?
· What’s the most common mistake new value investors make?
· How do you tell the difference between a cheap stock and an expensive one?
· How do you tell the difference between a safe stock and a dangerous one?
· How do you tell the difference between a good business and a bad one?
· How do you study a company?
· What’s the most important bad investment habit to cure yourself of?
· What’s the most important good investment habit to train yourself in?
· If you had to buy and hold one stock forever which stock would it be?
· What’s the stock with the biggest upside you don’t own?
· What’s the worst old idea you know is wrong, but you keep clinging to?
These are all much better questions than “what valuation method should I use?”.
There’s a reason Charlie Munger is obsessed with Ben Franklin. Franklin was the most practical founder.
Theory and Practice
About a week ago, someone asked me what I would teach in a class on value investing. We’ll get to my answer in a second. But let’s start with an even better one.
Warren Buffett has said Ben Graham’s The Intelligent Investor is “by far the best book on investing ever written.” He’s also said the 2 most important chapters are Chapter 8 (The Investor and Market Fluctuations) and Chapter 20 (Margin of Safety). Neither chapter deals with valuation.
This is what Warren Buffett said about Ben Graham when he spoke at Notre Dame in the 1990s:
“…(Ben Graham) may not know anything about a Coca-Cola, or something of that sort, but that isn’t what makes you the money. What makes you the money is your attitude going in, your attitude toward stock market fluctuations. There’s two chapters in The Intelligent Investor, chapter 8 and chapter 20, they’re more important than everything that’s been written on investments, in my view, before or since. And there’s no specific technical knowledge in those things. It just tells you what frame of mind to be in when you come to the game. And people just don’t get it…It’s not like I was Mozart and sat down at five or something…what I needed was a philosophical bedrock position from which I could then go out and look at businesses, and probe through that filter, and decide whether that’s (a bargain or not). And that’s Ben Graham’s contribution. And that’s the game. You don’t have to be that smart…half a dozen or more of us who had gone on to study or work, or have some association with Ben Graham…we were there just because we kind of stumbled in. And we listened to the guy and then went out and applied it in different ways – totally different ways…There were all different types with a common philosophical bond. They did not learn any little secrets of technique – they did not learn any systems…To me, it’s absolutely fascinating that the teaching of investments has retrogressed from 40 years ago, and I think it’s probably because the teachers are more skillful. They learn all these huge mathematical techniques and they have so much fun manipulating numbers they’re missing something very simple…You shouldn’t buy a stock, in my view, for any other reason than the fact that you think it’s selling for less than it’s worth, considering all the factors about the business.”
I want to focus on that something very simple.
You don’t need a formula to value a company. In fact, there is no general formula that will prove as useful to your investing as the examples you collect in your head. Your way of thinking about investing, the patterns you recognize, the connections you see between different kinds of companies, assets, etc. will be more important to you than any formula.
When asked about what books I’d include in a course on value investing, I snuck in two non-investing titles:
1. The Structure of Scientific Revolutions
2. The Essential Tension
Both by Kuhn. These are good books for new investors to read. They show how a formula is not just a formula. A technique is not just a technique. It is part of how practitioners see their world. But it is the way they see the world that matters. What matters is how they think and talk about their subject.
And if you’re not willing to read Kuhn’s books – read what Warren Buffett said at Notre Dame, read Poor Charlie’s Almanack, and read The Intelligent Investor.
These are some of the shortest, best distillations of the ideas of Warren Buffett, Charlie Munger, and Ben Graham. And all 3 are surprisingly lacking in exactly how you should calculate a stock’s intrinsic value.
When you go racing off to do a DCF you are doing a lot more than you think. There are a lot of assumptions in doing a DCF – including the very big assumption that a DCF will give you the most useful estimate of a company’s value.
Why not calculate the company’s value to a private buyer? A competitor?
Assumptions, Assumptions, Assumptions…
I can do a DCF calculation for you using GuruFocus’s DCF calculator. If I was doing one for Exxon (XOM) I’d probably use the following assumptions:
· EPS: $5.86
· Growth Rate (Next 10 Years): 4%
· Terminal Growth: 4%
· Discount Rate: 10%
For earnings, I would use Exxon’s 10-year average net income divided by the company’s current share count. This is $5.86 a share. I use this approach because I’m unsure whether Exxon’s normal earning power has grown, shrunk, or stayed the same over the last 10 years.
The 4% growth rate for the next 10-years is because I’d guess population growth will be around 1%, inflation 3%, and oil consumption per person flat.
In the long-run, I’d use the same assumptions as for over the next 10 years, except that I’d expect world population growth to be lower than 1%.
Now, depending on whether I use a 10-year terminal growth period or a 50-year terminal growth period the DCF values XOM at between $68.49 and $98.06. The 10-year terminal growth period is absurdly short. The $98 valuation is realistic.
All of this uses a 10% discount rate, because that’s what I consider an acceptable annual return. This is a personal choice. I’ll hold cash instead of investing if I don’t find a stock I think will deliver 10% a year for the next 10 years.
Now, what if my only choice was between the S&P 500 and Exxon Mobil?
In that case, I’d use 7% as the discount rate. (Because I don’t think the S&P 500 will return more than 7% a year from today’s prices). That would bump up the intrinsic value of Exxon Mobil to $165 a share.
What does this mean?
Is Exxon Mobil worth $98 a share? Or is it worth $165 a share.
If you think you can get 10% elsewhere, it’s only worth $98 a share. If your only other choice is the S&P 500 – Exxon is more attractive than the S&P 500 at prices under $165 a share.
But think about all the assumptions I made. For example, I assumed that world oil consumption per person will not increase. Many people would disagree with this. Some people probably think world oil consumption will grow in lockstep with the world economy. If that was true, our intrinsic value estimate for Exxon Mobil could be as high as $270 a share.
So, you see Exxon Mobil could be worth anywhere from about $100 a share to $270 a share depending on what you think the right discount rate is and what you think oil consumption per person will stagnate, grow, or shrink over the next 50 years.
Of course, all of these estimates are meaningless – since we’ve been doing them for the company rather than the stock. Over the last 10 years, Exxon has bought back enough stock to lower the number of shares outstanding from 6.8 billion to 4.8 billion. And they pay a dividend of $1.85 a share.
Depending on how much of its earnings Exxon puts back into the business, how much it pays outs in dividends, how much it uses to buy back stock, and where its shares trade when it buys back that stock – the estimate could be very different.
My feeling is that $1 of earnings at Exxon is worth more than $1 of earnings at many other public companies. That’s because I think that an owner of Exxon shares will have earnings invested in a way that delivers better returns for them – through regular buybacks and dividends – than what you’ll find at most public companies.
So even if the assumptions that went into a DCF were identical for two companies in the same industry with the same competitive position – I might actually end up valuing the two companies differently. That’s because capital allocation would be different.
See how many assumptions we are making just to get an intrinsic value range of $100 to $270 a share for Exxon. And some people will disagree with the entire range of some of our assumptions. For example, some people will want a discount rate higher than 10%. (Some people use higher discount rates to adjust for risk).
There’s a much simpler way to invest.
Look at your choices. Buy the stock that is:
· Clearly undervalued
· You are most comfortable owning
· And offers the best annual return on your investment
For me, this is definitely not Exxon. Even if I thought Exxon was worth $270 a share – which I don’t, my own assumptions valued it at $98 – I wouldn’t buy the stock.
Exxon is nowhere near the most clearly undervalued stock I could buy. In fact, the potential undervaluation of Exxon hinges on the future value of oil. I have no idea what the future value of oil will be. So I have no idea what Exxon is worth.
Exxon is a much harder company to value than a net-net or an insurer or a bank. Now, the safety of the net-net, insurer, and bank may be harder to evaluate than the safety of Exxon.
If Exxon was trading at book value, we’d have a different story. If Exxon was trading at a very low multiple of its 10-year average earnings – it trades at just under 15 times its 10-year average earnings – we might have a different story.
But we don’t. So it seems to me that Exxon’s stock price is within a range of values where it is too hard for me to know if it is overvalued, undervalued, or fairly valued.
By the way, it’s a really wide range. For me, anytime Exxon is above $60 a share and below $300 a share I would have a hard time feeling confident I knew whether it was undervalued or overvalued. At 200 some dollars a share, I’d know it wasn’t very undervalued – but it could still be fairly valued. At 60 some dollars a share, I’d know it wasn’t very overvalued – but it could still be fairly valued.
We could use a thousand different valuation techniques and most of our answers will land within a range of values that doesn’t give me much to work with.
3 Simple Stories
Compare this to 3 very different stocks I’ve mentioned before:
1. Bio-Reference Labs (BRLI)
2. Gencor (GENC)
3. DreamWorks (DWA)
1. Bio-Reference Labs grew 20% a year for the last 17 years. You can read the annual letter from the CEO and see he expects the company to continue growing 15% a year. The company has a P/E ratio of 18 right now. If it grows earnings 15% a year for the next 10 years and then trades at a P/E of 15 – you’ll make 13% a year buying BRLI today and holding it for 10 years. All you need to figure out is whether or not BRLI will grow into a $2 billion plus business within 10 years.
2. Gencor has $8.20 a share in cash and investments. The stock sells for $6.95 a share. If the company is truthful in its reporting, the question you have to answer is what Gencor’s other assets are worth? Is the company’s operating business and associated inventory, land, buildings, etc. worth some positive number or some negative number? If the operating assets are worth more than zero, you are clearly paying less than the company is worth. (By the way, here’s my recent article on Gencor.)
3. Finally, DreamWorks Animation. The company is trading for 1.1 times book value. You need to look at the way DreamWorks accounts for its previously released films and its investment in films yet to be released. And then you need to decide whether the way DreamWorks accounts for its movies causes the company’s book value to understate its economic net worth by at least 10%. If you’re sure it does, you know the stock is undervalued. (And here’s my recent article on DreamWorks).
This was Warren Buffett’s point about Ben Graham not knowing how to value Coca-Cola but that it didn’t really matter. Ben Graham didn’t need an opinion on Coca-Cola.
If you have an opinion about Bio-Reference Labs, you don’t need an opinion about Gencor or DreamWorks.
If you have an opinion about Gencor, you don’t need to know anything about urine samples or movies.
And if you have an opinion about DreamWorks, you don’t need to spend a second worrying about net-nets.
Charlie Munger and Walter Schloss didn’t buy the same stocks. You don’t need to have a very big investment universe. You don’t even need to know how to value something precisely.
You just need to start with something you think you can figure out.
I know I can’t figure out Exxon. But maybe I can understand a balance sheet (Gencor), a growth company (BRLI), or a movie studio focused on making a couple animated movies a year.
Start with something you can understand. This is what Warren Buffett told Bob Woodward:
Bob Woodward one time said to me “tell me how to make some money” back in the ‘70s, before he’d made some money himself on a movie and a book. I said “Bob, it’s very simple. Assign yourself the right story. The problem is you’re letting Bradley assign you all the stories. You go out and interview Jeb Magruder.” I said “Assign yourself a story. The story is: what is the Washington Post Company worth? If Bradley gave you that story to go out and report on, you’d go out and come back in two weeks, and you’d write a story that would make perfectly good sense. You’d find out what a television station sells for, you’d find out what a newspaper sells for, you’d evaluate temperament.” I said “You are perfectly capable of writing that story. It’s much easier than finding out what Bill Casey is thinking about on his deathbed. All you’ve got to do is assign yourself that story… Now, if you come back, and the value you assign the company is $400 million, and the company is selling for $400 million in the market, you still have a story but it doesn’t do you any good financially. But if you come back and say it’s $400 million and it’s selling for $80 million, that screams at you.”
It’s not a good sign if you’re worried about whether you’re using the right valuation method. You should be looking at something where you feel you trust your own common sense valuation a lot more than you trust a DCF.
[b]Ask Geoff a Question about Assigning Yourself the Right Story
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