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Robert Abbott
Robert Abbott
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Strategic Value Investing: Choosing Valuation Models

What valuation model should you use? In most cases, it will be determined by your investment style and the types of stocks you prefer

September 17, 2019 | About:

What’s next, now that you’ve chosen an investing style based on personality traits such as patience and attitudes toward risk, as well circumstances such as your need for income and your tax situation?

The authors of "Strategic Value Investing: Practical Techniques of Leading Value Investors," Stephen Horan, Robert R. Johnson and Thomas Robinson, explain that you can now proceed to choose one or more valuation models because you know or better understand your investment style.

As you may recall from earlier sections of the book, there are several models we can choose from:

We’ll briefly address each of these in the context of investing styles and stock sector choices.

Dividend discount models

These are the simplest and most commonly known models, and they have an important and obvious constraint: They can be used only with stocks that pay cash dividends. In the 1950s, when the model was conceived, most companies paid dividends. But the proportion has shrunk since then. For example, the authors cite the research of Eugene Fama and Kenneth French, who found 66.5% of American stocks paid dividends in 1978, but only 20.8% paid them in 1999.

If your investing style pushes you toward large-cap companies, however, you’re in luck because more than 80% of S&P 500 stocks were paying dividends when this book was written (it was published in 2014).

In terms of sectors, you will also find dividend stocks in more mature industries such as utilities, real estate investment trusts and consumer staples. All of these are expected to fit with a cautious investment style.

Companies that usually do not pay dividends or pay very small ones are often small caps, as well as in sectors such as technology. At the time this book was written, only about 40% of stocks in the Russell 2000, a small-cap index, paid dividends and their yields were significantly lower than the yields from S&P 500 stocks.

Free cash flow models

As we learned in an earlier chapter, free cash flow models come in two forms: free cash flow to equity and free cash flow to the firm. They can be broadly applied, whether a company pays a dividend or not, and are most frequently used when investors want to value an initial public offering or a private company.

They can also be applied when the company pays a dividend, but are much different than the cash flow to equity. For example, the authors cited the case of Apple (AAPL), which pays a dividend, but that dividend is quite small in comparison with the “enormous” free cash flow it produces. The same holds for companies temporarily paying higher dividends than their free cash flow justifies.

Free cash flow to the firm might be used to value a company if its leverage is expected to dramatically change, as is the case with a leveraged buyout situation.

As the examples suggest, free cash flow models will be more suited to investors with a more aggressive stance.

Asset-based models

Save asset-based models for unique situations. According to the authors, you would use this method when you think management is not making the most of its asset base, and a change in management would produce more earnings power. This suggests these are models for activists and the followers of activists who seek to enhance shareholder gains by shaking up a company.

But these models can also be used when management is performing well; the authors wrote, “In Chapter 9 we presented an example of an asset-based approach valuing Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), suggesting that it is undervalued with a margin of safety of roughly 12 percent. I doubt that many commentators would posit that Berkshire Hathaway is an underperforming or mismanaged firm.”

These models also are called upon when valuing companies with major holdings in natural resources. They give the example of a timber company that reduces its harvesting when commodity prices are depressed. In a case such as this, the dividend discount or free cash flow models might seriously undervalue a company, as well as its earning potential.

Residual income models

Banks operate differently than companies in other sectors. They earn a spread on the difference between what they pay for deposits and what they can charge for loans. Because of this, it is not easy to establish their operating cash flows.

Residual income models generally work for companies such as financial firms, where book value and earnings drive profitability. Or these models can be applied when cash flows are not predictable, but earnings are quite stable. This obviously rules out companies that have questionable earnings quality.

Relative valuation models

Unlike the other models here, relative valuation models compare a company’s metrics with some other company’s or group of companies. The authors called it a good “first pass” model to create a shortlist of potential purchases, which is then followed with analysis using absolute valuation models (dividend discount, free cash flow and residual income).

Using this model by itself could lead to problems because a stock may be the lowest priced for a good reason—its prospects are dim, for example. There is also the possibility that the entire group might be overvalued. The authors pointed to the case of Bill Miller and his big position in financial companies as the financial crisis of 2008 unfolded. The entire financial industry had been overvalued.

Different relative models apply to different industries and sectors. Banking stocks are assessed using price-book models, while retailing is usually assessed by same-store sales. Companies in the technology sector are valued according to their growth prospects and commonly revolve around their price-earnings to growth, or PEG, ratios. Price-to-cash flow is frequently used when analyzing big cash-generating companies such as those in the REIT and utilities sectors.

Conclusion

Investment styles and valuation models are directly or indirectly tied together. Your investment style, defined, for example, by your caution or adventurousness, will point you toward certain classes of stocks.

As we’ve seen, cautious investors will lean toward large-cap stocks, while adventurous investors will lean toward small caps. Thus, cautious investors will likely use dividend discount models more often, while adventurous investors might use free cash flow models more frequently.

The authors of "Strategic Value Investing: Practical Techniques of Leading Value Investors" concluded, “Which investment valuation model you select will, to some extent, be dictated by your investment style. Many value investors have a preferred valuation method but are not averse to employing other methods as circumstances dictate.”

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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dirt2624
Dirt2624 premium member - 1 month ago

I prefer the equity bond model using BV growth average (5 or 10 year, which ever is less) forecast for 5 years and apply 15 year average P/BV for future price and discounted at 15% to give an intrinsic value estimate. Been doing that since the 80s but GF makes it a lot easier than when I had to go to the university library and go thru valueline binders for hours - LOL.

Robert Abbott
Robert Abbott premium member - 1 month ago

Thanks, Dirt2624 for adding to our knowledge about valuations! And, I'm old enough to agree wholeheartedly than many things have become easier over the decades. Bob

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