How to Practice Valuation
Why? What do these books have in common?
They aren’t the best written investment books. Nor do they have the most profound concepts. The best concepts in that list both come from The Intelligent Investor. So, if all I am recommending is books with great principles, great theory – in them, I’d just tell you to read Chapters 8 and 20 of The Intelligent Investor.
The reason I recommend those books is that they make investing seem like a lot of work. A lot of practice. They use a lot of examples. And they encourage you to play along at home.
Some of Buffett’s annual letters do the same. Who can read the annual letter where he mentions Arcata– or the one where he looks back on the See’s purchase– and not imagine what you would do. How you would frame the problem?
Investing is mostly practice. You get good at investing by investing. By reading 10-Ks. But, most importantly, by valuing companies. You’re going to do this badly at first. And you’re going to lose money doing it.
There’s a bit of advice often given to new writers. You have one million practice words in you. Your first book doesn’t have to be any good– no one will ever read it. It will be terrible.
And it is. Always. But it’s also practice.
This is as hard to hear as an investor – maybe harder – as it is for the wannabe novelist. You have to do a lot of work. It’s going to be bad work. And it will bring you only rejection, ridicule, etc. Later, when you look back on it, you too will agree – it’s pretty bad. You may also lose money – and you’ll definitely lose time – as a result.
This is the really unfortunate difference between investing and music, sports, etc. If you want to practice pitching you usually get to do it as a kid. The first time I ever threw a pitch in a baseball game I was in the third grade. The batters – little children – were terrible. It was good practice. Because their skill level was matched to mine.
Even better, when I had a bad game – it was over. I didn’t have to relive it. No one videotaped it and replayed it for me. It was not filed away in a drawer. And – most importantly – it didn’t cost me any money. It was bad. But it was momentarily bad.
Practicing investing doesn’t work that way. It isn’t anything like the momentary humiliation of hitting someone in the foot with an errant fastball or making a horrible screeching sound on your violin.
It will make you feel more than momentarily stupid to screw up in investing. It will cost you money. And – because you’re going to write it down, record it in a brokerage account, etc. – it will also be preserved for all time.
Get over it.
There’s no other answer. All practice is unpleasant because it is short-term pain for long-term gain. Practicing investing is more unpleasant because there is no way to match your competition to your skill level.
There is no maiden race to run in as a value investor. They start you in the Kentucky Derby.
That’s not quite true. If you’re smart, you start with microcaps. And – if you’re not an American – you start with your home country. Later, you will have to graduate – if you do this professionally – into bigger stocks. For individual investors, you can mostly stay in microcaps. And – for everyone but folks living in the very tiniest countries – you can invest in your home country.
You should too. Take it from me – an American – if you don’t live here, you probably shouldn’t invest here. The best competition is here. There isn’t more opportunity. Just more eyes focused on the same stocks.
So, those are the first steps. You’re going to practice valuing microcaps. And – if you don’t live in the U.S. – you’re going to start in your home country.
A lot of you are going to ignore this advice. You really shouldn’t. Competition gets much tougher as the float and especially number of analysts – really a proxy for institutional eyes – increases.
Every common sense quality backtest I’ve tired – quantifying the ideas of Buffett, Fisher, Lynch, etc. – works so much better when applied to stocks with almost no analysts. It also works well with low float stocks.
A strange – but good – rule of thumb is to put stocks with the lowest number of shares outstanding at the top of your to do list. Keeping share count low – and not splitting the stock – tends to be a sign of not really caring about Wall Street.
Length of time since going public is also a good metric to keep in mind. Companies that never really had an IPO – they were spun-off, diced up for creditors, resulted from a legal case, etc. – are excellent stocks to look at. Otherwise, the rule is pick things that didn’t just go public. Pick old stuff.
So, that’s where we start. We start small, out of the way, old, odd, etc. Above all else – don’t pick a stock with a lot of analyst coverage. I’ll give you 2 analysts. You can value anything with two or fewer analysts no more.
For the record, I think there have been times where that would allow you to research stocks as big as Berkshire Hathaway (BRK.B) and Seaboard (SEB). For this exercise, analyst coverage – or rather lack of analyst coverage – is more important than market cap. So, for instance, John Wiley (JW.A) is a better choice to practice on than Q-Logic (QLGC) even though John Wiley is bigger.
Here’s why. The value in Wiley is in the academic journal business. The closest peer – they’re exactly like Wiley just double the size in every respect: journals, article submissions, revenue, etc. – is Reed Elsevier. That’s a U.K./Dutch company. And I really mean slash. They have two sets of shares. The comparable part – Elsevier – is the best part of Reed Elsevier. But it’s only part of the company.
So, when I say John Wiley you may be thinking books, textbooks, or academic journals. If your mind went to books – that’s misleading because it hardly contributes any value to the company.
There is no pure play publicly traded peer. If you talk to customers – university libraries – and say “academic journal” they’ll immediately answer: “Elsevier and Wiley”. But to investors, these businesses are only segments of larger publishers and so they are less analyzed as standalone businesses.
That’s good. That’s the kind of thing we want.
So, you can practice on Wiley – which I’m going to use as an example. But you’d be better off practicing on other stocks I own – I don’t own Wiley – like George Risk (RSKIA) or Ark Restaurants (ARKR).
I call the valuation process “appraisal”. Most of my time is spent analyzing a company, not valuing it. I ask whether this is something I understand, want to own, etc.
What we’re practicing here isn’t that. We are just talking appraisal.
Here’s how this works. You get one sheet of paper. And only one sheet of paper. You have to fit everything you want – words, numbers, charts, etc. – on one side of a sheet of paper.
What do you put on this page?
Imagine two friends come to you. One is having money trouble. He owns some John Wiley stock. Imagine that stock doesn’t trade – and never has. He has no idea what it is worth. But he needs to raise some cash. A mutual friend likes the company – but also has no idea what it is worth. He’d like to help the selling friend out by buying. Neither wants to take advantage of the other. They know you are better valuing businesses than they are. They turn to you for a fair appraisal.
Now, show your work on one sheet of paper.
I recently did this – for myself – for John Wiley. The result is something that reads more like notes for a speech I’d give – or maybe some sort of weird geometry proof – than something you’d share with other.
It’s very simple. I’ll quote the opening.
“John Wiley has 3 businesses:
That frames the entire discussion. At no point will we discuss other assets. I am appraising three parts: journals, textbooks, and books. I’m simplifying. Wiley gives these businesses different names. For example, there’s actually some software – it’s really small – in the books business. I don’t care. We need a way of identifying the assets. This is it.
Wiley’s only assets are operating businesses. If they had land, I’d list that here. If they had a film library, I’d list that here. If they had a money losing business – I wouldn’t list that here. Why?
Because this is an appraisal. If you asked me to appraise a piece of property with a valuable house and some other building the owner is losing money maintaining – I’d just tell you to rip it down and what that would cost. I wouldn’t assume it will cost you money for ever unless you want it to.
Use common sense. Never appraise a business unit at less than zero. Wall Street can do that if it focused on EPS. You’re not allowed to in an appraisal process.
Likewise, I use enterprise value in appraisals. That’s how I’d appraise a business. It might not be how you expect the stock to trade next month. But that’s not how I treat this exercise. I imagine that – while other stocks do trade – this thing I’m looking at is a business on the auction block, it is not just a stock subject to the whims of sentiment this week, month, etc.
In some cases, this is critical. Last year, I analyzed Mediaset. If I appraised it based on either European stocks at that moment or companies exposed to the Italian advertising business at that moment – I’d get very different values. Instead, I looked at it as if the Italian government would let some random foreigner buy the whole thing.
They wouldn’t. But that’s how I appraised it. The resulting appraisal was vastly different than the stock price. That doesn’t mean the stock price was wrong relative to other European media stocks, etc. – I didn’t do that comparison.
So focus on the idea that you are being asked to appraise this as a totally illiquid investment. You are probably going to use publicly traded peers and sales of controlling stakes in businesses – both public and private – but you aren’t going to ask whether traders like stocks in the country, industry, etc. this quarter.
In the Wiley example, I then went on to three sections. Each section used the same format. This is why I say it looked like a geometry proof.
Line 1: Name of peer trades at x times sales and x times EBIT
Line 2: At x times sales, Wiley would be worth blah blah
Bullet: The actual arithmetic
Line 3: At x times EBIT, Wiley would be worth blah blah
Bullet: The actual arithmetic
Appraisal: Average of the two figures
I did that for journals (Elsevier), Textbooks (Pearson), and Books (Scholastic). Then I added them up.
It’s as basic as it sounds. This is what the actual stock valuation looked like:
Wiley’s businesses are worth $4,478 million.
· $3,663 million (Journals) + $671 million (Textbooks) + $138 million (Books) = $4,478 million
Wiley has $543 million in net debt.
· $673 million (debt) + $204 million (pension) = $877 million (obligations)
· $877 million (obligations) - $334 million (cash) = $543 million (net debt)
Wiley’s equity is worth $3,935 million.
· $4,478 million (business value) - $543 million (net debt) = $3,935 million (equity value)
Wiley’s stock is worth $67.05 a share.
· $3,935 million (equity value) / 58.69 million shares = $67.05
The idea is to lay a clear line of thinking down. Don’t get involved in side arguments. For example, Scholastic is a terrible choice of a peer. I looked for others. I almost used a different (French) company – but it was too complicated to break out.
The important point is that $138 million divided by 58.69 million shares is $2.35 a share. And the multiple on the books segment – because I averaged an EV/Sales and EV/EBIT approach – is just 0.3x sales. In other words, say you think it should be 0.15x sales. That changes the valuation by $1.20. And 0.3 is a low multiple already.
I could write 2,000 words about what the value of Wiley’s book business is. But, because we drew a clear logical line of thought through our appraisal process – we can see it doesn’t matter.
If you can’t value it – set it aside. The stock would then be worth $65 a share. The segment doesn’t lose money. And if it did, you could sell it to someone with more scale in books. It’s a moot point.
The journal business. Any arguments for or against the stock should be centered there.
Because I also presented some margin of safety math. I always end my appraisal with this. For me, margin of safety is the ultimate bottom line. Here’s what it looked like for Wiley:
Margin of Safety
John Wiley stock has a 28% margin of safety.
· $2,672 million (market cap) + $543 million (net debt) = $3,215 million (enterprise value)
· $4,478 million (business value) - $3,215 million (enterprise value) = $1,263 million (discount)
· $1,263 million (discount) / $4,478 million (business value) = 28% margin of safety
Margin of Safety: 28%
Note that I used enterprise value. If we used stock price the margin of safety would be 32%. It doesn’t matter a lot here. But I think that would be misleading. If you applied that thinking to something like Weight Watchers (WTW) which I just bought – it would distort you into thinking there’s a huge margin of safety. There isn’t. There’s a huge upside because the stock is sitting behind a lot of debt.
I don’t include upside in my appraisal. I only do a per share appraisal and a margin of safety – using enterprise value.
Once you have this one sheet appraisal page, you can pick apart the argument. Is Reed Elsevier a good comparison? Is Pearson?
What about the pension obligations?
You can also quantify these points. For example, dickering over what the right comparison is for the textbook business is not that important. No one would value the textbook business at one times sales. So, you’re talking about a point of contention that – at most – could potentially alter your view of the stock price by like $5 a share.
It’s a fine argument to have. But you want to enter it starting with the topic already being quantified. Any argument about the book business is an argument over maybe $2 a share. Any argument over the textbook business is maybe – since no one will say it’s worthless – an argument about $5 a share.
This brings me to the pension obligation. It appears on the balance sheet as $204 million. I would treat it differently. That’s a discussion for another time.
But, let’s say you are just starting out and you’re not real sure how to deal with pensions.
First, quantify the problem. Is this going to risk John Wiley’s solvency?
No. Wiley has a couple hundred million of free cash flow. You can tally up the pension assets and obligations using the extended notes in the 10-K. If you were a creditor, this would not cause you to worry about Wiley’s solvency.
But could it eat years of free cash flow? Could Wiley pay into the pension fund instead of buying back stock, paying a dividend, etc.?
Exactly. That’s how I would look at it. It’s similar to whether a company will pay down debt.
It’s something of an appraisal issue. But you can probably feel that the questions involved here are bigger than what you want to deal with on one page.
I wouldn’t put it on my one page. I’d spend some time thinking about whether the pension would lead me to skip this investment.
Where do you go from here?
Well, if you think a 28% margin of safety is enough – you research the stock further. You would focus on the journal business. The bar for proving the value of the other two businesses is very low. In fact, you could argue the entire enterprise value of the company doesn’t actually exceed the value of the journal business.
What could really wreck your appraisal?
A change in multiples for companies like Reed Elsevier, Pearson, and Scholastic.
Is that likely?
It’s quite possible. I would look at where they traded historically and – more importantly to me, what they actually returned.
For example, John Wiley itself has for a few decades now beaten the market without necessarily starting at a really low price. In other words, these businesses have often justified these relative multiples.
Aren’t EBIT multiples around 13 – which is what many of these businesses trade for – too high?
In a normal interest rate environment – in a normal Shiller P/E stock market – they would be.
There’s a huge risk your margin of safety could disappear due to interest rate increases and EV/EBIT contractions for the whole market.
That’s not a stock specific argument. It’s not even an industry specific argument. I think it’s totally valid. But, in my experience, it’s hard to appraise companies truly absolutely. You really can’t – when bond yields are 12% – treat every business as if it’s fine to yield 6%. Today, we have the opposite problem. It’s present in all stocks.
You can decide how to treat it. I would mostly use relative valuations. For me, I treat high overall stock valuations as decreasing my future return potential.
That’s a separate issue. I ask 3 questions:
1. What is each share of the stock worth?
2. What is my margin of safety?
3. What will holding this stock return each year?
I’d like the answer to #3 to always be at least 10%. I’d like the answer to #2 to be at least 33%. John Wiley fails this. It didn’t at one point last month. And then, obviously, I need each share of stock to be worth more than what I am paying.
I don’t teat question #3 as an appraisal question.
This is where Ben Graham folks and Warren Buffett folks butt heads. For me, John Wiley is not worth more than $67 a share. It is, however, a business that might offer better returns at that appraised value than other companies.
In theory, the market should handicap stocks so they offer the same future returns from now until the end of time. In practice, this doesn’t really happen.
I think the appraisal value is something you can imagine a stock going to within 3 years. It is not – for me – a simple matter of a DCF.
As a result, some stocks are more attractive at their appraised value than others. I run a screen for stocks trading at a certain EV/EBITDA (always less than 8x, I prefer less than 5x) that have posted profits every year for the last 10 years.
If you backtest that list, you’ll find many stocks reappear over the years. Some return more than others. They all – if held for a year or two – tend to give you good returns. I mean, some fail because the business changes – it’s just a screen after all. But, if the business is in good shape – or the same shape – years later, the stock does fine.
But some of these stocks consistently do better than others when kept as buy and hold investments. What explains this?
As a rule, if you buy and hold a stock that’s consistently profitable and you pay less than a market multiple – it’ll work out. Sometimes it doesn’t beat the market. It may if you flip it within 3 years. But not if you hold it for 13 years.
The stock always earns 8% on equity. This drags down the return.
Now, should we correct for this. Should we always appraise a stock with an 8% ROE at half the value of a stock with a 16% ROE?
I don’t know the answer to that question. And until you deeply analyze both stocks – you usually won’t either. You would need to have more faith in the status quo than is usual in any microeconomic future. If chosen at random, I’d expect the 8% ROE might be able to go up and the 16% ROE might trend down.
Sometimes it won’t. John Wiley is an example where I think it won’t trend down.
How do I treat that?
Purely as upside.
I think of holding something with an ROE equal to or greater than my hurdle rate – let’s pretend it’s 15% for this example – as having no carrying cost. There’s no drag.
If I buy a net-net that will only return 8% a year – that has 7% drag. As a one year or three year investment – it probably works out great. But, as that price to appraisal value closes, I have this 7% opportunity cost that I’m paying year after year.
A lot of people cut the net-net in half for that – or double Wiley for that.
I don’t really think that way. I like to keep those concepts separate. The upside is the upside – that’s the part where you’ve either got the drag or you don’t – and the margin of safety relates to the discount to appraised value.
Other things equal, it’s better to own the good business. Can we mathematically put that into our appraisal? Of course. But how practical is that appraisal now – and how theoretical?
This brings me to discounted cash flows. Don’t do DCFs. I get a lot of questions about DCFs. And I don’t use them when valuing a stock.
Have I ever used a DCF?
I used a DCF twice in the last month or so. Both were more “proof of concept” DCFs than anything. Here are the two situations where I used a DCF:
1. A company had two classes of stock. One class of stock had different rights to dividends than rights in a liquidation.
2. A natural resource company had a lot of proven reserves. I assumed most of the value would be in the next 15 years of production. But there was some additional value in years 16 through 50, 75, etc.
In question #1, I knew what the stock should trade at if all returns came in the form of dividends. I wondered what it would take – when the dividends would have to stop and another transaction occur – to justify the difference between the two classes of stock.
In neither case did I start with the DCF. In both, I noticed an anomaly. I tried to explain it away with a hand wave – I must have misread the dividend rights, they must have low proven reserves that will run out soon.
In each case, further investigation supported the anomaly being unexplained or unjustified. I expected the company – because of its price – to have fewer years of proven reserves. It had a lot. I expected the dividend rights to be different than they were.
I thought common sense isn’t enough here. I need to actually do the math to see just what this means.
The practical applications of a discounted cash flow analysis are very, very limited. They are very special. You don’t need to practice them. There is almost always a simpler way to deal with the same principle.
Never include a DCF on your one page appraisal.
Finally, always try to do the appraisal without knowing the market price and then work down to the shares. If you stay at the company level – and don’t peak at the market cap – while you’re doing the analysis, you shouldn’t be too biased.
Most investors are biased in one of two ways. If they view this as practice, they are biased toward a valuation that comes close to the market price. To them, this means their appraisal is “right”. They use the market price as a check.
The other potential bias is if you studied the stock first. When practicing valuation, don’t value companies you already own. It’s good to do that for your own financial future – it’s bad as a way of practicing. You’re way too biased to deal honestly with those stocks.
If you read about a company, like it, etc. you’ll also be biased. You’ll try to justify appraising Coke (KO) at 30 times earnings.
Design your appraisal process based on examples. Don’t appraise the same stocks you see someone else do. For example – don’t go home and look at Wiley now. That’s forbidden to you. You already saw where I came out on that one.
Instead, take the format I used and go and value another company with 3 business segments.
Look for “worked examples”. Read “You Can Be a Stock Market Genius”. Read Joel Greenblatt’s class notes – you can find them at the bottom of this blog post. Go to the Value Investors Club. You don’t need to sign up for 90 day delayed access. There’s no reason to read the latest posts to practice – the older ones are probably even better practice (since you can see how they turned out).
You can also read Ben Graham’s articles. They are collected in two books you can find at Amazon (just search for Benjamin Graham). These collections of articles include more explicit valuation work than what you find in The Intelligent Investor, etc.
The important thing is just to steal the formats, etc. they use. What metrics do they look at? How do they break things down?
Then go and do it yourself. Don’t fall into the trap – I almost regret mentioning VIC – of just reading ideas. There’s no work in that. You can read one idea at VIC and then you have to go and do one appraisal page of your own. Don’t let yourself read 2 ideas, because you’ll end up reading 20 ideas – which is fun and no work – instead of practicing. Which is no fun and a lot of work.
Value blogs are good sources of worked examples. Follow the ones that cover specific micro caps and break out different business segments, come up with actual per share values, etc.
But none of this matters if you don’t practice. Most investors reading this are just going to go off and read the examples I mentioned. They aren’t going to do any work on their own.
If you just sit down and complete one appraisal – if you truly force yourself to put it all on one sheet of paper, give explicit logical steps with arithmetic, assign an actual per share value to the stock, and calculate the percentage margin of safety – you will be ahead of everyone else reading this in no time.
Very few investors do that. For the next week, do one appraisal a day. Do the best you can just working off a couple hours of reading the 10-K, checking peer values, etc. Give yourself 2 hours of research time and then draft the one page. Try to see if you can do that every day.
If you do that every day for a week – you’ll have learned a lot. And you’ll have learned that it’s a lot of work. You’ll probably be saying you don’t have two hours to prep for an appraisal each day.
For amateur investors, that’s certainly going to be true.
But do you have 1 hour a day?
Do you have 30 minutes a day?
You can certainly do 3 appraisals a week. Everyone has time for that. All you have to do is force yourself to do it.
It’s work. In fact, it’s more than work – it’s practice.
There are some pleasant aspects to practice. But first sitting down to do it – realizing what you have ahead of yourself, and not yet knowing how to frame the problem – is never pleasant.
That’s the biggest reason why I recommend reading – and if you’ve read it, re-reading – Greenblatt’s book. “You Can Be a Stock Market Genius” makes investing sound the most like what I actually do. And, more importantly, it makes it sound like a lot of work.
The most important thing you can do is the work. I get a lot of emails that are too hard to answer. They are very specific emails. But my answer to each of them would be the same.
They ask something about how exactly to treat the amount of cash a business needs, how exactly to treat the pensions for this one company here, how exactly to determine maintenance cap-ex.
My answer is always the same. First, there’s never a file attached showing me the work the person did. They don’t say: “Here’s my best appraisal” – did I do this wrong.
They say: “I don’t know how to do this.”
I’ll be honest. I don’t either. If you mean that I have a rule for exactly how to treat a situation that I both apply in all circumstances and actually think is theoretically the correct approach – and one that other investors I admire would treat the same way – I can’t think of many situations where that happens.
Valuation is not a magic system. It doesn’t work according to rules where if you say one word it works and if you do it wrong – it just fizzles out.
Every appraisal has blemishes. In my Wiley appraisal, I may have screwed up $7 there. I may have totally misjudged the pension – simply by not dealing with it on that one sheet.
I did the work. I filled up one sheet of paper with a clear line of logical thinking. It’s supported by evidence. There’s arithmetic there. If you want to take it apart, you can do that piece by piece following that logic. And we can see what that does to the stock price.
If you don’t do the work of appraising the stock because you’re scared of not knowing how to treat pensions or estimating maintenance cap-ex…
No one knows what maintenance cap-ex is. Management has a number they put in slides. In my experience, they are under estimating. Maybe they are hoping. But it’s usually wrong. And actual cap-ex comes in above what they say it’ll be.
So, even if you sat down with the CFO – you’re going to get the “wrong” number for maintenance cap-ex.
The important thing is putting down a number. Deciding how much that number matters. And doing the work. Practicing.
After 100 of these one page appraisals, you’ll get better. You will definitely get more confident. You won’t wonder how to tackle a problem. You just will tackle it. Later, you may rethink it. But you’ll start by trying things.
The quicker you can move from a passive observer and commenter on other people’s appraisal to practicing your own – the quicker you’ll graduate to being a real investor.
You have to practice. And now is as good a time as any. You won’t feel like practicing today. But it’ll be equally unappealing tomorrow. And it’ll be easier tomorrow if you did it today.
Last word: Under no circumstances are you permitted to go beyond one page. That’s what makes the practice difficult. You have to distill everything to just the logical case for that specific appraisal price.
You are going to be tempted to claim there’s no way to put it all on one page. You are going to claim that you need all this elaboration.
Remember this, I’m a guy who just wrote 5,000 words on how to practice appraisal. And yet, when I actually sat down to appraise John Wiley, I did it on one page.
That appraisal was to decide whether I would put 25% of my money into that stock. A lot of people reading this don’t blabber on for 5,000 words on appraisal. And they aren’t risking 25% of their money on one stock pick.
If anyone is allowed to go beyond one page it should be a verbose, highly concentrated investor like me.
I don’t. I stick to one page. There’s a reason for that.
You’ll appreciate the discipline of the one page appraisal if you really stick to one page. It turns work into practice. It makes it hard. Good. It’s supposed to be hard.
If you spread out your appraisal in loose prose over a bunch of pages, you’ll be sloppy about it. You won’t force yourself to find the actual logical line you’re following. And you won’t make your points as sharply – and be able to attack and defend them as specifically – as if you put it all one side of one sheet of paper.
So stick to one page. It’s hard. But it’s worth it.
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