Using book value, earnings per share and a company's dividend yield are all well-established ways to value a business. Some investors rely on these metrics to establish whether or not a company is undervalued compared to the rest of the market, or just undervalued compared to itself.
However, while these are some of the most established methods of company valuation, they also have significant drawbacks.
In his now out of print book, "The Margin of Safety," Seth Klarman (Trades, Portfolio) criticized each of these methods for their drawbacks. Each of them can be used in a valuation analysis, but he cautioned that they should always be used as only part of a more comprehensive valuation effort.
Klarman was particularly critical about earnings per share, a vital component of the price-earnings ratio. Specifically, he noted that the ratio does not "attempt to measure the cash generated or used by a business." In addition, "corporate management are generally aware that many investors focus on growth in reported earnings," and they try to massage the figures as a result.
Accounting rules can also have an impact on the figure. Klarman pointed out that generally accepted accounting principles (GAAP) "may require actions that do not reflect business reality."
Turning to book value, the value investor wrote, "What something cost in the past is not necessarily a good measure of its value today." While current assets are "usually worth close to carrying value," plant and equipment may be outmoded or obsolete, "therefore worth considerably less than carrying value."
Other factors can also have a significant impact on book value that is not necessarily reflected in the figures:
"Inflation, technological change, and regulation, among other factors, can affect the value of assets in ways that historical cost accounting cannot capture. Real estate purchased decades ago, for example, and carried on a company's books at historical cost may be worth considerably more. The cost of building a new oil refinery today may be made prohibitively expensive by environmental legislation, endowing older facilities with a scarcity value. Aging integrated steel facilities, by contrast, may be technologically outmoded compared with newly built minimills. As a result, their book value may be significantly overstated."
Finally, Klarman turned to dividend yield. This section of the book is relatively short. Klarman noted that although dividend yield was once considered to be a handy method to value a stock, this method has now become a "relic." Stocks should simply "not be bought on the basis of their dividend yield," he went on to add.
Investors buying stocks with high dividend yields may not be buying value at all. Too often, struggling companies support high dividend yields because management does not want to send a signal that the business is weak by cutting the payout. In this situation, rather than an indicator of good value, a high dividend yield can indicate a value trap.
In his concluding remarks for the chapter on stock valuation, Klarman declared that business valuation is a "complex process yielding imprecise and uncertain results." Some businesses are so complex they cannot be valued. Investors shouldn't try.
"Investors must remember that they need not swing at every pitch to do well over time; indeed, selectivity undoubtedly improves an investor's results. For every business that cannot be valued, there are many others that can."
Disclosure: The author owns no share mentioned.
Read more here:
- Seth Klarman's Advice on Portfolio Management
- Ben Graham on Market Fluctuations
- Benjamin Graham: How to Find Bargain Stocks
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