The Tricky Business of Valuation

What Are We Looking For?

In this first post I’d like to discuss something core to investing: valuation. Usually it takes a book's-worth to cover the topic, so I'll just touch on it on a more philosophical level in this whirlwind tour.

The most straightforward way you can try to beat a market is to buy assets for less than they’re worth, or at least less than what people will think they are worth in the future. The distinction is important. There is a difference between valuation and pricing. Namely, a valuation determines what something is intrinsically worth regardless of any existing prices (with the assumption that the market eventually has to agree with it), while pricing tries to compare an asset with other assets’ prices or the price of same asset historically (usually through the use of various ratios). Pricing has an implicit assumption that the market usually does a decent job at valuation, while intrinsic valuation is independent of the market. Sometimes pricing can sneak into a valuation in subtle ways, like using an EBITDA ratio to get a terminal value in a DCF. More on this later.

An asset can have a certain price for a variety of reasons. Some assets have real, but hard to calculate, value because they provide what economists call “utility”. They can be consumed or used to make something, like oil. Gold, on the other hand, is hardly ever used to produce anything useful; the vast majority of it is stored in the form of bars and sits in a vault untouched. It’s impossible to ascertain a true value for gold. The only reason we give it value is that it’s has a limited supply and we believe others will also attribute value to it in future. Sounds sketchy, but the fact that gold is completely agnostic to earnings growth or interest rates makes it one of the only good investments in times of high inflation and a stagnant economy, as in the 1970s. Overall, it’s impossible (or at least extremely hard) to get an exact estimate of the intrinsic value for an asset that doesn’t produce income. Everything is about how the current price might change due to changes in fundamentals or investor psychology. It’s all differential.

Valuing Income-bearing Assets

But, the kind of asset we usually deal with in intrinsic valuation is the kind, like stocks or bonds, that does promise to produce income. In theory, this kind of asset has a much more concrete and calculable value. It’s really as simple as adding up all the cash flows you expect to receive by owning the asset, discounted by an appropriate rate based on how many years you have to wait for each cash flow. This is called a Discounted Cash Flow (DCF) or Present Value calculation. In more mathematical terms, you take each expected cash flow and divide it by one plus the discount rate, to the power of the number years you wait (since discount rates are annualized): $$PV=\frac{CF_1}{(1+r)}+\frac{CF_2}{(1+r)^2}+...+\frac{FC_N}{(1+r)^N}$$

For some assets, like stocks, it can be hard estimate cash flows past say 5 or 10 years, so one would stop at that point and then attach a "terminal value" to encompass all the cash flows after that point. As mentioned before, some analysts will poison the intrinsic valuation by determining this value by taking an estimated earnings figure at this point (maybe EBITDA) and multiplying it by some reasonable multiple. An alternative is to pick a constant growth rate. Maybe you could use the average growth rate of the economy, since nothing can grow faster than the economy forever or it would eventually be the whole economy. The biggest issue I have with DCFs is that the bulk of the valuation goes into the terminal value, making all the careful estimates of cash flows kind of insignificant. That being said, the concept behind how an asset gets it's value is still important and we'll think a bit more about this problem later.

Discount Rates

In a DCF the discount rate, r, that you use is just as important as how much you estimate the cash flows to be. If the discount rate were zero you’d just be dividing by one, so each cash flow would be worth it’s expected dollar amount. But a rational person does apply a positive discount rate for two main reasons: opportunity cost and risk. If you could’ve invested your money elsewhere with no risk and received a non-zero return, then a certain amount in the future has to be worth less today, because that smaller amount could’ve grown into a larger amount over that time. And the more unlikely it is you actually receive a cash flow, the less that promised value is worth to you now. This is why we understand discount rates as being a risk-free rate (usually the yield of the 10-year US treasury bond if the currency used is dollars, since the US government is almost certain to pay it’s debt) plus some extra “risk premium”. For example, if the 10-year treasury yield is 2% and your stock has a typical risk profile, then we might assume a risk premium of 5% and get a discount rate of 7%.

For a bond the cash flows are fixed, so the valuation is entirely based on the discount rate. So, a bond’s value is dictated by what the central banks do to interest rates (the risk-free part) and how likely the bond issuer is to pay you back (the risk premium due to “credit risk”). Bonds are often said to be very sensitive to inflation. In times of high inflation investors demand higher interest rates because they know that these fixed payments will be worth less in terms of buying power in the future. Central banks also raise their benchmark interest rates to try to fight the inflation. As the interest rates go up, the discount rate for your bond goes up and your bond's value goes down. For stockholders the cash flows traditionally come in the form of dividends, but more recently another popular way to return cash is through stock buybacks (where the company buys it's own stock on the open market). By reducing the number of shares, each remaining stockholder has the promise of a bigger slice of the dividend pie in the future. As Warren Buffett likes to point out, buybacks aren’t a great move if the stock price is overvalued, because it takes more cash than necessary to reduce the share pool by a given amount. Plus, reinvesting that cash into the business might actually increase the dividend potential by a higher amount than by doing a buyback.

Liquidation Value

A second type of valuation, that was popularized by Benjamin Graham, is liquidation value. How much money would be left over for stockholders if we take the company’s cash, add the value of the inventory sold off in a fire sale (you might assume about half of the book value of the inventory), add the amounts collected from most of the accounts receivable (maybe about 75%) and subtract out any and all liabilities. Property, plant and equipment is assumed to be worthless, because often it's very difficult for these assets to be sold and repurposed. This is a conservative estimate of the amount that the stockholders would get if the company went out of business. Obviously, it's even better to take a closer look at what exactly is on the balance sheet to get more accurate estimates. Either way, some people find it confusing trying to reconcile liquidation value, which comes from balance sheet analysis, with the DCF valuation we talked about above that comes from the income statement. Those are two completely different values, so which is the value of the company? Does it just depend on how conservative your appraisal is?

The answer is that a liquidation payout is actually a cash flow; it is money you would receive for holding the stock. So, the value you use for a company depends on whether you think the company will survive or not. Either way you're technically doing a DCF. The smart thing to do is try to figure out how long you'd have to wait for your liquidation payout and discount it appropriately. If the company is likely to continue to operate as a going concern then the liquidation value is more of an insurance policy than anything. But beware of betting on failing companies with liquidation values that are high relative to price. If that company continues to operate and burn through cash, the liquidation value could erode and it could turn into what’s called a “value trap”. Graham made a lot of money betting on companies like this during the depression era. In those times perfectly good companies would trade below liquidation values, so it was like he had capped his downside and had unlimited upside. Opportunities like this still exist today, but are rare.

What If They Don't Pay Me Any Dividends?

Another problem a budding appraiser can have when looking at all this is thinking about companies that will seemingly survive a very long time with positive earnings, but appear to never actually pay a dividend. Can a company like this actually have value to a stockholder? One way to reconcile this is to value the stock based on free cash flow to equity. In theory, this is the adjusted operating income (accounting for maintenance capex and funding changes in working capital) that could’ve been paid out to stockholders after paying taxes and interest to creditors. It’s interesting to think about whether a theoretical payout is actually valuable to a stockholder. One could argue that the company might use the free cash flow to invest in growth capex, thereby increasing the potential for dividends in the future. But sometimes companies just add to the cash pile.

A better approach is to think about what the business would be worth to an acquirer, a big fish that could buy up all the shares. When an acquirer buys up all the stock, it is entitled to all the cash on the balance sheet, but also has assumes responsibility of all the debt. This means the true cost of acquiring a business is the market capitalization (the cost of all the shares outstanding) plus the debt, minus the cash. This is known as the enterprise value. Once this acquirer has bought the company, they then can have access to all the free cash flow to the firm (operating income adjusted for non-cash expenses net of tax). So, you can value the whole company based on the free cash flow to the firm using the DCF approach we discussed and compare it to the enterprise value to see if a company is undervalued to an acquirer. Note that you would use WACC (explaining this value is outside the scope of this post) as the discount rate in this approach, because the acquirer could use both debt and equity to fund the the overall company. This provides you with a concrete way to value the equity (by adjusting for debt and cash) and once again, if that company is acquired, you as a stockholder receive a definite cash flow in terms of the money you get for being bought out.

A final, but more difficult way to appraise a stock’s value is to look at the replacement value. Here we’re thinking in terms of how much it would cost to rebuild the same company starting from cash. This forces us to estimate how much it would cost to build up some of the intangible assets of the business, like relationships or brands. So, you can think of a stock that doesn't pay a dividend as having value because of arbitrage. If investors didn't give the stock a high enough value, then it would get acquired because the acquirer would know that it costs less than building that business themselves and/or they could get access to cash flows that are worth more than the going price of the company.

How Do I Even Use This?

You might be thinking that all this is pretty complicated. How do I feel confident about DCFs that I create? How can I use this in investing? I like some of the suggestions that Bruce Greenwald has put forward. Instead of trying to predict every aspect of the future and do an accurate valuation, anchor on what we know now and make broad brush strokes for thinking about the future. For example, if you know the earnings today and have an approapriate discount rate, you can see what the company would be worth if the cash flows never changed. This is the "earnings power value" of the company or stock. Then if the stock is priced below this value you could ask yourself "is this company ever going to grow it's earnings?" If the answer is yes, then the stock is probably undervalued. If the stock is trading below it's liquidation value, you can ask if the company is likely to fail or if it's likely to burn through it's current value. These are different ways to think about valuation that don't require an exact estimate of cash flows years from now.

Even if you do make rough estimates for future cash flows, you don't need to worry about whether your valuation is exactly correct. Benjamin Graham sums it up well when he wrote: "To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight". Valuation is a tool that might not tell you the exact value of a stock, but you can at least tell when the price is completely out of whack and that is when you've found an opportunity that can make you a lot of money.

Final Word

Thanks for reading the first Note From The Admin. If you want to learn more about valuation I recommend Professor Aswath Damodaran's video lectures. Feel free to take a look at the utils this site has to offer. I'll be adding more and more over time and hopefully some of them will aid you in your search for undervalued opportunities. Feel free to email me at if you have questions or comments.