“Price is what you pay; value is what you get.” – Warren Buffet
Market Buzz – A Crash Course in Valuation
For those that have followed KeyStone’s research and commentary on a regular basis, there is a single term that you have heard us discuss repeatedly – valuation. We commonly refer to valuation both when describing our overall investment philosophy and when explaining the investment merits of a particular company.
Warren Buffet once said, “Price is what you pay; Value is what you get”. What Buffet is saying is that intelligent investment practise differentiates between market price and value. Most of us have an innate concept of what value is in our everyday lives when we shop for houses, household products, automobiles, and just about anything else. We have a sense of what something is worth to us and whether or not the market price of that product is lower or higher than the value we will receive from it. In the consumer market this concept of worth or intrinsic value is often difficult to quantify and highly subject to emotional whims which can result in the consumers overpaying for products that they don’t need and eventually don’t use. We have all paid a high price for a product from which we initially thought we would get years of enjoyment and which quickly ended up collecting dust in the back corner of the basement. Whether consciously or unconsciously, in our minds we arrived at a perceived intrinsic value of that product which was above the price we were asked to pay. But in the aforementioned example, we did not adequately assess the real intrinsic value of the product as we were distracted by emotional desire and short-sighted analysis. This happens commonly in the investment market as well.
When we refer to a specific company’s valuation, we are typically talking about some form of price multiple which could be price-to-earnings, price-to-cash flow, or even, price-to-book value. Mathematically, these concepts are quite simple. As illustrated below, one simply divides the current share price by the earnings, cash flow, or book value per share.
Price-to-Earnings Multiple = Share Price / Earnings per Share
5 Times = $5.00 (share price) / $1.00 (earnings per share)
Value investors typically look for companies that trade at a relatively low valuation multiple. In most cases, with everything else being equal, the lower valuation multiple, the better the value, and the more attractive the investment. But in the real world of investing, everything else is rarely equal and this is what makes the practise of intelligent investing more complex than a simple mathematical calculation. Truthfully speaking, if the only thing an investor had to worry about was calculating valuation multiples then we could all be as rich as Warren Buffet. Unfortunately this is not the case.
The simple fact of the matter is that no two companies are identical. Some companies in the same industries may appear similar but they can still vary widely in quality due to management ability, financial position (balance sheet), earnings quality, competitive advantages and future growth (or lack thereof). For example, a value investor may find two companies with company A trading at a valuation multiple of 6 times reported earnings and company B trading at a multiple of 12 times reported earnings. With everything being equal, company A appears to be more attractively valued. However, when we conduct a deep analysis of the companies, we may determine that company A’s earnings are expected to be cut in half over the next year, while company B is expected to double their earnings. Therefore, company A’s valuation over this period is actually 12 times earnings and company B’s valuation is in fact 6 times earnings. The situation has been reversed and although at the start of the analysis, company A looked more attractively valued, we actually discovered that company B had the better valuation. A similar scenario occurs when the expected growth rates of each company are similar but one company has a more sustainable earnings profile or lower financial risk which can also warrant a higher valuation multiple. Warren Buffet who is considered a value investor himself also said, “I would rather buy a great company at a reasonable price, then a poor company at a great price.” In many (perhaps most) cases, a very low valuation multiple is in fact an indication that the company is higher risk or lower quality. It is up to the analyst to determine what constitutes an appropriate valuation given all of the attributes of the particular company and its market. The numbers help us to understand the relative value but they do not by themselves tell the whole story. They are simply one piece of a much larger puzzle.
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