What is intrinsic value, or any stock valuation for that matter?
In chapter six of their 2014 book, "Strategic Value Investing: Practical Techniques of Leading Value Investors," the authors recommended a process for arriving at a reasonable valuation.
Authors Stephen Horan, Robert R. Johnson and Thomas Robinson suggested the five-step process used in what they call a “seminal text,” “Equity Asset Valuation” (by Gerald E. Pinto, Elaine Henry, Thomas R. Robinson and John D. Stowe, 2010):
- Get to know the industry and the company (fundamental analysis).
- Forecast the company’s performance.
- Select the right valuation model.
- Turn the forecast(s) into valuation inputs.
- Apply and interpret the valuation model.
The authors emphasized that it’s necessary to go through each of the steps in order, and not to skip any of them. They wrote, “Each step follows from the one preceding it, and if you exclude one you are not really practicing value investing; you are playing a guessing game.”
Understand the company and industry
- What are the competitive forces in the industry?
- What drives profitability?
- What are the key metrics?
- Where does the company fit in the industry?
- What is its economic moat, or is it a commodity producer?
- What has driven the company’s historical financial performance (i.e., return on equity)?
- What are management’s strengths and weaknesses?
Forecast the company’s performance
Using the information gained in step one, understanding the company and industry, the second step is to forecast sales, expenses, earnings, dividends and financing requirements for coming years. The authors added, “We find that translating an understanding of the industry and company into specific forecasts of company performance is the most challenging part of the process for the strategic value investor because it involves translating the subjective into the objective.”
Forecasting generally involves the use of top-down or bottom-up analysis. If it’s a top-down approach, a value investor will use macroeconomic data to estimate future sales and sale prices for the industry, and then attach them to the company’s market share and relative pricing strength.
Using a bottom-up approach, the investor would develop a sales forecast based on smaller units, changes in the company’s capacity or the number of retail stores. According to the authors, “A rich forecasting analysis frequently incorporates elements of both these approaches. For example, an analyst might use a bottom-up approach to build an overall sales forecast across different product lines. The forecast within each product line, however, may be constructed using a top-down forecast.”
Selecting the appropriate valuation model
Many valuation models exist, but no particular model will work for all companies. To simplify the world of valuation models, analysts divide them into two main categories:
- Absolute valuation models.
- Relative valuation models.
Absolute valuation models are company-specific and based on fundamental factors. The category takes in dividend discount models, free cash flow models, asset-based models and residual valuation models.
Relative valuation models establish values based on comparisons with other securities. This category includes price-earnings, price-book, price-sales, price-to-cash flow and price-to-Ebit models (all absolute and relative models are discussed in detail in following chapters).
According to the authors:
“The best model needs to be consistent with the characteristics of the company being valued, data availability and data quality. For example, dividend discount models, which rely on dividend forecasts, work well for utilities and other companies with stable or steadily growing dividends. Dividend discount models are not appropriate for companies that do not pay dividends, such as some technology companies or start-up firms.”
Turn the forecasts into valuation inputs
Sales forecasts and projections of other metrics are essential for developing value estimates, but the problem with forecasts, as always, is that the future is unknowable.
Enter sensitivity analysis, which analysts use to measure how much variation will result from changes to the inputs. For example, if a small change in your assumptions about sales growth generates a big change in the value estimate, then you would say your model is very sensitive to sales growth.
By knowing which inputs are most sensitive to input changes, you know where to focus your analytical efforts. If small changes in your assumptions about sales growth lead to big changes in a value estimate, you will spend more time studying that issue. On the other hand, perhaps changes in interest expenses have little or no effect on your estimates; in that case, you can spend less time on the cost of debt.
Apply and interpret the valuation model
Having gone through the four steps above, in order, you are positioned to make a real investment decision, as in buy or don’t buy and sell or don’t sell. You have a reasoned estimate of intrinsic value, and by comparing that value with the market price, you know the margin of safety.
But perhaps you’re still uncertain because you don’t know if the margin of safety is wide enough. Here’s where sensitivity analysis comes to the rescue:
“The size of the margin of safety is not a fixed value. It depends on how confident you are in the model’s inputs and how sensitive the valuation is to changes in those inputs. The less confident you are about the main value drivers and the more sensitive intrinsic value is to those inputs, the greater the required margin of safety.”
The authors also recommended that investment decisions should also involve the state of your portfolio. As they pointed out, a series of investments may look fine on a standalone basis, but be too risky if gathered together in one portfolio. Think of a portfolio comprised of just oil companies or just real estate stocks. The authors wrote, “All else being equal, the strategic value investor would demand a larger margin of safety for a less diversified portfolio.”
Conclusion
The authors of "Strategic Value Investing: Practical Techniques of Leading Value Investors" have provided a five-step process for establishing robust valuations of stocks.
Robust because the valuation is based on deep knowledge of the company and industry, using that knowledge to forecast the company’s performance, choosing the right valuation model and by turning the forecast outputs into valuation inputs. After all of that is done, it’s then a matter of applying the model, and interpreting the valuation that emerges.
Read more here:
- Strategic Value Investing: Company Analysis, Part 5
- Ă‚ Strategic Value Investing: Company Analysis, Part 4
- Strategic Value Investing: Company Analysis, Part 3
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