1. How to use GuruFocus - Tutorials
  2. What Is in the GuruFocus Premium Membership?
  3. A DIY Guide on How to Invest Using Guru Strategies
Mark Lin
Mark Lin
Articles (212) 

Dispelling the 10 Myths of Valuation

December 20, 2013 | About:

Value investing falls into two general categories: (1) buying good companies at reasonable valuations (compounders); and (2) purchasing average or even poor companies at substantially below their intrinsic values (cigar-butts). Valuation is critical for both investing approaches. While a great deal of literature has been devoted to the assessment of company quality, valuation frameworks and methods have been unfortunately left in the cold. Before even diving into the actual valuation of stocks, investors will do well to avoid the following valuation myths.

1. Valuation is static.

It is a universal truth that the only thing that remains unchanged is change itself. One of the most common mistakes an investor makes is to commit to a buy or sell decision for stocks based on outdated data or information. For example, the latest Net Asset Value (NAV) for a stock based on the most recent 10-Q, should be considered for P/B valuations. For investors using dividend yield as a valuation criterion, they need to watch for any changes or potential changes in company dividend policy, and downgrade in earnings guidances or forecasts if dividends are distributed as a percentage of earnings.

2. A stock trading at less than 10x P/E is cheap (or 8x EV/EBIT for that matter).

It is quite astonishing the amount of times I have heard this uttered to me as a gospel of truth. Many stocks have never traded above 10x P/E in their trading history, and are likely to remain that way, given their lackluster earnings track record. Similarly, there are some stocks who have never traded below 10x P/E in their listing history, typically companies in high growth industries and sectors with strong prospects of exceptional earnings growth. A simplistic rule of thumb is not applicable to all stocks equally.

3. A stock trading at less than 1x P/B is cheap.

This is based on the premise that the value of a stock should not be more than the value of the company’s assets less its liabilities on the balance sheet. The problem lies with the fact that the assets and liabilities on the balance sheet comprise a mixture of historical, market and estimated values, which may not reflect the real intrinsic or saleable value of the company. For example, a company which invests in listed stocks or has listed subsidiaries will have such assets marked-to-market (such assets need to be recorded at their market values updated quarterly); but in the scenario of huge and volatile stock market movements during the most recent quarter, the current balance sheet figure for such assets may not reflect their most current values. For stocks which trade consistently at P/B above or below 1, a possible reason is that their asset values on the balance sheet do not fully and accurately reflect their earnings power. Buying more tables and chairs does not contribute to McKinsey’s profitability.

4. Apples are comparable with oranges.

Many stocks are touted as bargain buys simply because they trade at a significant discount to their peers in the same industry on various valuation multiplies, like P/E or P/B. The mere fact that a stock trades at a significant discount to its peers on one of the valuation metrics is not sufficient reason to determine if a stock is undervalued. Usually, there are very good reasons why this is the case. For example, REITs which own properties in different sub-sectors of the property market may trade at vastly different valuations, i.e. hospitality REITs are regarded as riskier than retail REITs. This is because retail units usually have longer lease terms calculated in terms of number of years; while the average stay at hotels is anything from a few days to a few weeks.

5. All oranges are equal and should cost the same.

There are no identical oranges, just like that there are no identical stocks. Even stocks in the same line of business may trade at different valuations, simply because they have different earnings growth profiles and risk factors. Understanding the valuation drivers such as margin stability and growth for the individual stocks in the same industry is the key to knowing why they are valued differently in the market.

6. A DCF model produces superior results compared with P/E and P/B.

A typical DCF Model requires more valuation inputs and multi-year financial forecasts, but this does not necessarily guarantee a superior and more accurate valuation. In some instances, having more assumptions backing the valuation model may obscure the key underlying valuation drivers from the view of the investor. The adage “Less is more” is applicable to valuation too. Using fewer valuation inputs and learning how they impact valuation, is by far more crucial than using many valuation inputs with little or no understanding of how they contribute to value.

7. It is important to be as accurate as possible when it comes to valuation, down to the last decimal place.

It is better to be vaguely correct than precisely wrong when it comes to valuation.

8. A stock trading below its long term average P/E and P/B ratios is always cheap.

History provides a useful context or background for comparison, only if the stock or company has not experienced major changes in business model, management or strategy over the years. Furthermore, certain historical events may affect some stocks to a larger extent than others, e.g. a case of food contamination will have a more severe impact on F&B and hospitality-related stocks.

9. A stock cannot be valued because of...

Have you heard something along these lines before? “The stock cannot be valued because it is newly listed...” “The stock cannot be valued because it has no comparables in the same industry...” The correct response is, “Yes you can value the stock, but you need to use... or make the following assumptions...” There is at least one valuation model or method for every stock; never say that any particular stock cannot be valued at all.

10. Valuation does not matter.

The Benjamin Graham quote comes to mind: “In the short run the market is a voting machine. In the long run it is a weighing machine.” Stock prices may be subject to wild irrational fluctuations in the short term, but true value will persist in the long term and reward staunch believers in value.

About the author:

Mark Lin

Rating: 3.3/5 (8 votes)


Seanickson - 3 years ago    Report SPAM
good list.  Personally I believe a DCF model is superior but your basic point is sound and it should be kept as simple as possible.  One of the most common myths I hear is that small and value stocks should outperform others because they have in the past. Of course valuations have changed and whats worked in the past, wont necessarily work in the future.

Please leave your comment:

Performances of the stocks mentioned by Mark Lin

User Generated Screeners

jlhpersonalJason's Greenblatt - Updated L
dosowsky1Fast Revenue Growth
Kbannon77All Stocks US
Kbannon77All Stocks
opadovaniP median2
carter2u2Small Cap No Debt
bkw82Predictable/ebitda 10/52 week
pbarker46Hist. High Yield
Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)

GF Chat