In a recent article one of the best writers on GuruFocus, Geoff Gannon, wrote the following: "The value investor in me – the stuff I learned from the books I read in my teens – rebels against the idea of paying a high (price-earnings) P/E for anything. That’s a mistake. It’s better to pay 30 times earnings for a company like Luxottica (LUX, Financial) than 10 times earnings for a company like Weight Watchers (WTW, Financial)."
This caught my attention. In my previous article I discussed the difference between classic value investing and dynamic value investing. As I went back and thought about what I wrote, I realized that I omitted something that I should not have, which led to this article.
A few years ago when I first started my journey on value investing, I thought the same – one should rebel against the idea of paying a high P/E for anything. Today, I too, think it is a mistake. Because a high multiple, while on appearance may imply rich valuation, should not be categorically indicative of value at all. Value has little to do with P/E multiples and as value investors, our goal is to define value, not spotting valuation multiples.
Naturally this leads to the key question: What is the intrinsic value of a business? Here we all know that the theoretically correct answer is given by John Burr Williams and famously quoted by Warren Buffett (Trades, Portfolio):
"The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset."
In practice, we are faced with the conundrum that while we have the theoretically correct formula, we cannot determine precisely the future cash inflows and outflows. But this should not prevent us from applying the intrinsic value framework. We can modify Williams’ value definition so that it can have practical applications. My own version of intrinsic value is the following:
"The estimated intrinsic value of business today can be calculated by the thoroughly and rigorously analyzed best estimate of projected cash inflows and outflows – discounted at an appropriate opportunity cost – that can be expected to occur during the investment holding period."
From this definition, we can see there are three elements of value:
- Projected future cash flow (including growth rate).
- Opportunity cost-based discount rate, which should also include various other considerations such as the predictability of the business.
- Holding period.
Now we can see the problem I have with the popular claim that stocks with a high P/E multiple are expensive so value investors should rebel against this notion of buying a high P/E stock – all three elements of intrinsic value are missing. What is the projected cash flow and what is the projected growth rate of cash flow? What is the appropriate discount rate for a specific company? What is your holding period?
Is a company that has 15% free cash flow margin growing 15% more expensive at a current static P/E of 30 than a company that has 2% free cash flow margin growing at 2% with a current static P/E of 10? It depends on how you view the world. If your holding period is one year, you would need to project the free cash flow at the end of the one year and assign a free cash flow multiple on the one-year terminal cash flow and discount it back for one year using your discount rate. If your holding period is 10 years, you would need to project the free cash flow at the end of the 10-year period and assign a free cash flow multiple on the 10-year terminal cash flow and discount it back for 10 years using your discount rate.
In my previous article, I wrote about two stocks as examples – Apogee Enterprise Inc. (APOG, Financial) and Intuitive Surgical (ISRG, Financial). Let’s go back to the beginning of 2006. Apogee was trading at an enterprise value-sales (EV/S) multiple of 0.8 times and Intuitive Surgical was trading at roughly 22 times. The investment result you get will be vastly different if you hold both for different time periods – one year, two years, three years, five years or 10 years. You will have different cash flow projections and you should use a different discount rate for Apogee versus Intuitive Surgical. The longer the time horizon, the more the outperformance Intuitive Surgical holds over Apogee and the shorter the time horizon, the less clear which stock is cheaper.
A very classic yet somewhat misleading argument for the cheapness of a stock is based on book value or liquidation value, whatever you want to call it. In this case, book value becomes the surrogate of intrinsic value and if a stock is trading below book value, it is perceived to be cheap. But is this so? Shouldn’t we answer the following questions before concluding?
- Why in this case is book value a good measure of the intrinsic value of this company?
- Is book value likely to grow or shrink from current levels? At what speed?
- Why should the gap between book value and stock price close?
- When will the gap between book value and stock price close?
I think many investors take it for granted that you are getting a great bargain if you buy a stock trading below book value. Maybe partly because this is statistically true and definitively quantifiable. But without answering the above questions, it is precarious at best and reckless at worst to draw any conclusions.
By the way, I am by no means proposing we should buy stocks trading at 30x P/E multiples. My purpose is to seek the answer to one of the most important questions in value investing – what is value?
Value has little to do with multiple, especially in the long term. In the short term, I would caution that we should all be aware of the peril of becoming a disguised value investor.
Let me end with a long, great and seemingly fitting Mungersim:
"Another thing I think should be avoided is extremely intense ideology because it cabbages up one’s mind.
"You’ve seen that. You see a lot of it on TV –Â you know, preachers for instance. You know they’ve all got different ideas about theology and a lot of them have minds that are made of cabbage.
"But that can happen with political ideology. And if you're young it’s easy to drift in to loyalties and when you announce that you’re a loyal member and you start shouting the orthodox ideology out what you’re doing is pounding it in, pounding it in and you’re gradually ruining your mind so you want to be very careful with this ideology. It’s a big danger.
"In my mind I got a little example I use whenever I think about ideology and it’s these Scandinavian canoeists who succeeded in taming all the rapids of Scandinavia and they thought they would tackle the whirlpools in the Aaron Rapids here in the U.S. The death rate was 100%.
"A big whirlpool is not something you want to go into and I think the same is true about a really deep ideology."
Disclosure: No positions.
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