“There’s no such thing as superior information – only existing information used in a superior way.”
- Marty Whitman
In the real world, just as in Lemonville, everything has both a price and a value. Understanding the difference is the key to success. A stock’s price and value are often far apart.
If we buy a car, we know there’s the price tag on the car, and there’s also the actual, “Blue Book” value. In a market with many rational buyers and sellers, the offering price should factor in that value and the final sales price should match it closely. In other words, the market is efficient. An efficient market prices things accurately. The more informed buyers and sellers who behave in a logical fashion, the more efficient a market becomes.
The stock market is somewhat efficient, meaning it prices stocks at rational levels over the long term. But on any given day, the stock market is driven by alternating cycles of fear and greed which distort prices away from their fair value. Swings in sentiment affect stocks immediately because they can be bought or sold in an instant, with just a click.
At times, the stock market has what Alan Greenspan famously called “irrational exuberance,” an unfounded optimism that causes it to overprice stocks. Other times, the market is “depressed” and ignores value, mispricing stocks to the downside due to collective pessimism or panic.
The wise investor neither worships stocks at times of optimism, nor scorns them at times of panic. To paraphrase Rudyard Kipling’s poem “If”, the trick is to meet “with Triumph and Disaster and treat those two impostors just the same.” To understand markets is to be relentlessly rational in a sea of irrational behavior: to “keep your head when all about you are losing theirs.” As the Buddhists will tell you, both bullishness and bearishness (optimism and pessimism) are just different forms of delusion. Only realism, with an unemotional eye on the present, is worth cultivating.
At times of unbridled optimism or unfounded pessimism, the market is usually “wrong,” and assets are mispriced. People often behave irrationally, especially when they see their neighbor doing so, and especially at times of stress. If someone screams “fire” in a crowded movie theater, it doesn’t pay to stop and consider if it’s a false alarm, just as in the jungle, it didn’t pay to wait and watch the predator approach. Never mind that the person may be running for a completely different reason. Primitive crowd behavior often leads to market inefficiencies, where stocks are priced too high or too low.
In the world of markets, the person who can apply rational behavior to an inherently irrational market has a big advantage. A rational buyer or seller can weigh the facts independently, ignore crowd behavior, and make a lot of money buying things others are selling — or selling things others are buying. This type of investing, where you look to buy the unfashionable stocks and sell the fashionable ones, is called contrarian investing. It looks for value in places where people see none in order to get a bargain price.
This leads to Lemonade Law #10:
In markets, a careful consideration of the facts is warranted before any decision. Those who shoot first and ask questions later will often have shot themselves in the foot. “Don’t just do something, stand there,” is the contrarian motto for the astute investor. Diligently assessing value, while others react emotionally to price, is the best way to invest.
So how do we determine the true, underlying actual value of a share of stock and see if it matches the price? To find these answers, we must look to the company’s financial statements: the balance sheet, the income statement, and the cash flow statement. These are the sources of real value, or the lack thereof.
Let’s start with the balance sheet valuation. Think of a balance sheet as a snapshot of the business at a moment in time, a picture of what the business owns (assets) minus what the business owes (liabilities).
The assets of a business include things like fixtures and furnishings (fixed assets), money in the bank (cash), and money owed to the business within a short period of time (accounts receivable). Lucinda Lemonade Inc. owns a couple of tables, chairs, and lemonade pitchers; has some money in a checking account; and is owed some money by a few customers. The liabilities of a business are usually things like a debt, or payments due to suppliers (accounts payable). For example, Lucinda Lemonade Inc. once owed $50 to George and always owed a few dollars to the grocery store where Lucinda bought lemons on credit.
Here is Lucinda Lemonade’s balance sheet:
LUCINDA LEMONADE INC.
BALANCE SHEET
(As of 1/1)
The final number is most important. This is called the shareholders’ equity (also called book value), which tells you how much the shareholders own at the end of the day. If you take all the “Assets” and subtract all the “Liabilities,” you end up with this net value, which is owned by the shareholders.
If a company has a negative shareholders’ equity – it owes more than it owns – the shareholders own nothing. If the company were dissolved and all the assets sold, there would not be enough assets to cover liabilities, and the shareholder would end up empty-handed.
Lucinda Lemonade Inc.’s balance sheet shows that the company owns more than it owes, which means the balance sheet analysis will value the company at a positive number. In fact, Lucinda Lemonade’s shareholder equity is $103.00 – the shareholders own $103.00 on the balance sheet.
Now we can do some simple division to determine the shareholders equity per share. When Liam bought a share, he bought 10% of the company. According to the equity on the balance sheet, 10% of the business is worth $10.30 in shareholders’ equity.
If Liam’s tenth of the business is worth $10.30 on balance sheet basis, it looks as though Liam got himself a decent deal: he paid 30 cents less for his share than the book value per share would indicate that it’s worth. Liam has acquired an excess value of $0.30 per share. We can therefore say he bought the share at approximately a 3% discount to its book value.
Most important, with cash of $89.70 (nearly equaling the total liabilities of $92.37) on the balance sheet, Lucinda Lemonade Inc. is not likely to go bankrupt. A successful company with a large cash position relative to its liabilities is not likely to fail.
With an earnings valuation, we look at the earnings instead of the balance sheet. Earnings are the same as the net income we mentioned earlier. Earnings can be defined as the money you’re making selling lemonade minus the money you’re shelling out for lemons, sugar, wages, and all other expenses. If a company has earnings, it’s collecting more than it’s spending. The business is profitable.
When you buy a share in a company, you’re buying a piece of that company’s assets, but you’re also buying a piece of that company’s earnings. Just as any owner owns every cha-ching of the register, so too does a shareholder. The company may distribute these earnings to the shareholder in one of two ways: (1) It might pay them out in the form of a dividend, a periodic payment, or (2) it may reinvest the money in the business, which will presumably reward the shareholder through a capital gain, a rise in the company’s stock price as the business increases in value over time.
In either case, the shareholder will be buying a piece of the net income of the company and should put a value on that piece. To get the net income of any company, we need to see its income statement.
An income statement will show the income and expense flows of a company over one year. While the balance sheet is a snapshot of the company at a moment in time, the income statement is more like a moving picture, or film, showing the condition of the company over a period of time. The income statement takes the sales, also known as revenue (all the money taken in), and subtracts the expenses (all the money paid out) to calculate the earnings:
The actual income statement looks like this:
LUCINDA LEMONADE INC.
INCOME STATEMENT
1/1 to 12/31
Lucinda Lemonade had earnings of $135.20. Earnings are the net figure, meaning the actual money left over after all the company’s expenses have been paid. Earnings are also referred to as net income or profits. From the income statement, you can learn many things. You can see that Lucinda Lemonade makes nearly all its money as would be expected: from lemonade and iced tea sales. She has a small amount of miscellaneous income from whatever else she’s done on the side — maybe consulting for a lemon grove — but obviously her income is highly dependent on the cold drink market. A careful analyst of this data can see that Lucinda’s income stream is relatively undiversified, or concentrated; it could run into trouble if the cold drink sector runs cold.
On the expense side, you can see that the bulk of the costs come from payroll. Lucinda pays nothing in rent and utilities, a significant perk for the lemonade stand owner. Her expenses are minimal, which allows her to keep a high profit margin — the ratio of money kept after all expenses have been paid. The actual profit margin, or net margin, can be determined by simply dividing the earnings by the revenue:
An investor could then compare Lucinda Lemonade Inc.’s profit margin with that of competing lemonade companies and determine which has the highest margin. Consistently high margins are often the result of good management and a good business model.
Now that we know Lucinda Lemonade’s earnings, we can put a price on them. When someone buys a share of stock, remember they’re buying the future earnings stream of the company. How much is someone willing to pay for a future dollar of earnings? The answer to this question changes with market sentiment. When people are optimistic, they’re willing to pay a higher amount for any given dollar of earnings. When things look cloudy, they won’t. The price people are willing to pay for any given dollars in earnings is called the price/earnings ratio, also known as the p/e ratio. To solve for the p/e ratio, you divide the stock’s share price by the earnings per share (EPS):
If Lucinda Lemonade earned $135.20 last year, with 10 shares outstanding, the EPS is $13.52. If Lucinda Lemonade is trading at $200, then we divide that stock price by the EPS:
The p/e ratio for Lucinda Lemonade Inc. is 14.8. Note that this is the p/e ratio on trailing earnings, that is, on earnings in the past. It is therefore known as a trailing p/e ratio. This p/e ratio means that for every dollar of past earnings in Lucinda Lemonade, the market is willing to pay 14.8 times that amount in price. If Lucinda Lemonade is expected to earn $180 ($18 per share) in the coming year, then the forward p/e ratio would be determined like so:
The p/e ratio on forward earnings is 11.1. People are only willing to pay 11.1 times earnings for Lucinda’s future stream of profits, perhaps because they’re skeptical that Lucinda will actually earn that much. After all, a forward earnings projection is just that: a mere projection, subject to error. Forward p/e ratios will usually be lower than trailing p/e ratios since the “e” (the earnings) typically increase year to year. However, in a recession where earnings are expected to decline in the future, the forward p/e could be more than the trailing p/e. Always be sure you know whether you’re dealing with future or trailing p/e ratios before you make investment decisions.
A p/e ratio means nothing in and of itself. The logical question is what is the right p/e ratio a buyer should be willing to pay. Or said differently: what’s the correct price someone should be willing to pay to buy a share of a company? 11 times earnings? 14 times earnings? 100 times earnings?
When you buy a house, you look at comparable homes to get an idea of what you should pay. When you buy stock, you should do the same with companies. Let’s say that you wish to buy a share of Lucinda Lemonade Inc. You review the calculations above and recall that the future p/e ratio for Lucinda Lemonade is 11.1. You compare other p/e ratios for lemonade stand companies and find that the average future p/e is 13. You therefore determine that Lucinda Lemonade is selling for a cheaper price — a lower multiple — than the average lemonade stand. You might think that buying a share in Lucinda Lemonade at 11.1 times earnings is a good deal.
But your analysis can’t stop there! There might be a very good reason that Lucinda Lemonade’s shares are selling at a discount. Perhaps Lucinda Lemonade is being sued by a disgruntled employee. The public is aware of this suit and is accounting for the possibility of a big judgment by paying less per share. A careful investor might then do some research to determine if the lawsuit will be successful. Based on an educated estimate, if an investor feels the case will not succeed, he might feel that paying 11.1 times earnings is a decent deal.
Many investors feel that p/e ratios are too simplistic to really give an accurate picture of relative value. As you’ve seen, p/e ratios are subject to distortion by future events. And p/e ratios only reflect the relationship of price to past earnings or to earnings in the near future. They do nothing to account for the potential long-term growth rate of the company. That’s why some investors prefer to look at a PEG ratio, the relationship between the p/e ratio and the company’s expected earnings per share growth rate. The PEG ratio is computed as follows:
For example, If Lucinda Lemonade has a p/e ratio of 11.1 and an expected growth rate of 10%, then the PEG ratio is determined as below:
Again, the PEG ratio means nothing in and of itself. It’s only used as a reference in relation to the PEG ratios of comparable companies. If other lemonade stands have an average PEG ratio of 1.3, then shares in Lucinda Lemonade might be cheap and thus worth purchasing.
The PEG ratio at least looks at growth and earnings to get a decent picture of a company’s prospects. Note that even the PEG ratio does not attempt to account for the risk of the investment. People are willing to pay more for a faster growing company. But people should also theoretically be willing to pay less per share for a riskier stock than a safer stock. Just as people will pay more for a car if it goes faster and looks good, they will (and should) also pay more for a car that’s safe and reliable. Unfortunately, none of these ratios measures risk, a fact that limits their usefulness.
Another problem with valuation ratios is that they never tell the whole story. A valuation ratio is called a relative indicator, meaning it can only be useful when compared to another company’s valuation ratio. Like fingerprints, no two companies are exactly alike or easily comparable. Even stocks we think of as exact mirror images of each other are not really that similar. Take the example of Coke and Pepsi. These two businesses are considered so similar that they’ve given birth to a saying to describe sameness: “just like Coke and Pepsi.”
In reality, Coke and Pepsi are not that similar. Coke only makes drinks. Pepsi does too, but Pepsi also makes snacks like Frito-Lay potato chips. The drink business and the snack business are completely different, with different net margins and different growth potential. To compare Coke and Pepsi based on p/e or PEG ratios to determine which is cheap and which is expensive is really a flawed exercise. Pepsi might have a higher p/e ratio than Coke, but if the snack business is growing faster, then the premium might be justified.
How then do we value companies without falling into the relative value trap? We’ll come to that when we discuss free cash flow valuation, in the next chapter.
“A billion here and a billion there, and pretty soon you’re talking real money.”
- Everett Dirksen
Remember how we used net income (earnings) to value stocks. First, we determined the “e” – or the earnings of the company. To that we applied a “p” – the price of the stock. We divided the “p” by the “e” and came up with the p/e ratio, a measure of relative value.
Surprisingly, the “e” number in the denominator of a p/e ratio is a “made-up” number in some ways. It doesn’t necessarily reflect the real money that was left in Lucinda Lemonade’s cash register after paying expenses. The “e” is what might be called an “accounting fiction,” a number literally invented by accountants. Accountants determine what the “e” should be based on complex rules for depreciation and amortization, big words for non-cash expenses that are reflected as deductions on the income statement but don’t reflect cold, hard cash leaving the cash register.
Even though they don’t represent outflows of real cash money, they do reflect real expenses — expenses that are borne over time. They don’t lead to actual cash withdrawals at the exact time they are incurred.
Imagine that Lucinda buys an expensive electric juicer that can juice twenty lemons per minute. She buys it for $1,000 cash. In the year she buys it, $1,000 will fly out of the cash register to pay for it. The juicer is a capital expenditure (a long-term improvement to the business in the form of a physical asset), so accountants will not list the full $1,000 as an expense on the income statement; instead, they will amortize, or spread, this expense over the “life” of the juicer — perhaps 10 years. They will count one-tenth of the juicer’s $1,000 cost (or $100) as an expense each year for 10 years. In the first year, only $100 will be deducted as an expense, in the second year another $100, and so on. Amortization is used to reflect the fact that the juicer loses value as it ages and might need to be replaced in 10 years.
But this accounting rule leads to some strange results.
If we look in Lucinda Lemonade’s cash register drawer at the end of year 1, it will hold $1,000 less, due to the purchase of the juicer:
But Lucinda’s income statement for the same year will show only $100 of the $1,000 missing:
Through the magic of accounting, Lucinda’s net income is $2,200, while her actual new cash money in the cash register is only $1,300. Her net income overstates the real money that she collected during the year.
In the following year, the situation will reverse and her real money will be greater than her net income (all else being equal). She doesn’t have to pay any more real money for the juicer because she already paid for it last year, so we can reflect that with a zero in our statement of cash flows:
The income statement will once again show the $100 loss, as required to show the amortization, the juicer’s annual loss of value:
So now her real money is $2,300, $100 greater than her net income, which is still $2,200.
We call this “real money” free cash flow. Free cash flow is the actual money coming or leaving the business in any given year. Unlike net income, it’s not based on rules or accounting fictions. It’s based on reality.
As you can see, net income, or earnings, is dependent on many different accounting adjustments that actually change the free cash flow into a completely different number. Why do people pay so much attention to earnings when it’s just a made-up number? Why don’t they just look at free cash flow? The answer is that earnings show one legitimate view of the business while free cash flows reflect another. Both numbers tell a different story, but both stories are important. The net income expresses the idea that certain expenses are incurred even when money doesn’t actually change hands. The free cash flow shows the real money changing hands. You can’t really understand a business without looking at both figures and analyzing the difference between the two.
The mistake people often make is to ignore the free cash flow number and only look at net income. People on Wall Street are obsessed with earnings predictions, but you rarely hear them talk about free cash flow. Since net income is subject to accounting rules, it can be easily manipulated, and changed within certain guidelines. Dishonest management can alter accounting treatments to boost their net income in bad years. Free cash flow is much harder to manipulate and should always be compared to the net income. A company that has free cash flow lower than its income might be using accounting tricks to artificially pump up its earnings. On the other hand, a company with free cash flow exceeding net income could be an overlooked cash cow — undervalued by a market preoccupied with the earnings result.
Always look at both free cash flow and net income to understand the true finances of any business. In Lemonville, as on Wall Street, the knowledgeable investor considers both.
Did you know that the value of any business is the sum of its future free cash flows? Sounds so simple it can’t be right. But it is. The actual worth of any company, whether it be a lemonade stand, a hot dog stand, or multinational corporation, is the sum of all the eventual free cash flows that the company will produce, adjusted for the time value of money. Estimating these future free cash flows and using that to value the company is called Discounted Cash Flow Analysis or DCF. Despite its appealing and apparent simplicity, DCF is hard to do. An elaborate explanation of DCF is way beyond the scope of this book, but every investor should know that the professional way to value a business is to use DCF analysis.
Assuming Lucinda Lemonade’s free cash flows are expected to be $100 next year, $200 in year two, and to grow 10% per year for three additional years, we could begin to try to value her business by sketching out those cash flows like so:
Estimating cash flows seems to require the impossible: predicting the future. No one has a crystal ball, even in Lemonville. So how do we figure free cash flows in upcoming years?
First, we have to understand the business well: its historical growth rate, its market, its net margin, and its future prospects. No one can ever know exactly, but someone who really studies the business can make an educated guess. Second, we need to be conservative in our estimates: if we know the past annual growth rate of the business was 12%, it makes sense to use something less in our prediction. Better safe than sorry.
Finally, we can use what’s called a discount rate — a measure of risk — to discount, or mark down, those cash flows. The discount rate reduces the value of those future cash flows to what’s called a present value, their value today. The discounting process adjusts the value of the future cash flows for the risks presented by the time value of money: (1) the risk that inflation reduces the value of money over time, (2) the risk that those cash flows may never materialize, and (3) the risk that we could have always invested in something else.
For example, if we believe that inflation will run at historical averages and that Lucinda Lemonade is a business with “average” risks, we might design a valuation model using a discount rate of 10%. The average discount rate used for most stocks ranges from 8-15%, but this varies widely based on the risks of the company; the riskier the company, the higher the discount rate. Discounting the future cash flows to the present means working backwards to take each cash flow and reduce it for each and every year until that particular cash flow is expected to occur. If you think about it, discounting is really the opposite of compounding.
If we discount Lucinda Lemonade’s free cash flows to the present at a rate of 10% — to account for the risks involved in valuing the future — we apply the discount rate to each free cash flow and work backwards, “uncompounding” the amount for however many years until it’s expected to arrive. Then we add them all together:
Unlike a person, a business can theoretically last forever. So we need to assign some value to the additional years beyond the five year forecast period. We need to value these additional cash flows conservatively to recognize that the growth rate of any business slows eventually. As it’s often said, if any business grew faster than the broad economy’s average growth rate of 3% forever, it would end up bigger than the whole economy!
To value the uncertain, slow-growth future, we use what’s called a perpetuity, a stream of cash that goes on forever. We can value this perpetuity based on a never-ending low growth rate of 2% (for example) discounted back to the present at the discount rate. The discounting of lesser growth rates into infinity leads to the very distant cash flows being worth little, allowing us to establish a value for the future perpetual value of the company. This value is called the terminal value.
If Lucinda Lemonade’s perpetual growth rate is 2% and the discount rate remains 10%, we can solve for the terminal value by taking the free cash flow in the year just after the forecast period (which would be $292.60, assuming another 10% rate of growth from year 5 to year 6) and applying a formula that derives the perpetual value and then discounts it to the present. We won’t bug you with this complicated formula, but you can find many websites that calculate “terminal value” by typing those words into Google.
By this calculation, the discounted terminal value would be $2271. If we add the sum of the discounted cash flows of the forecast period to the discounted terminal value, we get $3022:
We take that sum and add it to the cash on the balance sheet (subtracting any debt) to get the business value:
Finally, we take the business value and divide by the number of shares outstanding — et voilà! — we get the actual value per share of the business:
We can then compare this actual value per share to the market price per share. If the price per share is substantially less than $305.48, then Lucinda Lemonade’s stock is undervalued and potentially worth buying. If not, it isn’t.
Now that you’ve learned the basics of valuing a company, beware of all that learning! Designing a valuation model can be satisfying, but valuation is more art than science. No one can value any company precisely. It just isn’t possible. Avoid falling in love with your own valuation models. Always question your own assumptions — again and again. Remember: any computer can crunch numbers, but it takes a human to think. As programmers say, “garbage in, garbage out.” A model is only as good as its assumptions. If your model is built on poor inputs, it’s worse than having no model at all. Commenting on the pitfalls of models, Warren Buffett has said “I’d rather be approximately right than precisely wrong.” That sums it up pretty well.
For those who would prefer to use the valuation models of professionals, both Morningstar (www.morningstar.com) and Trefis (www.trefis.com) provide objective DCF valuation of companies. Trefis has the additional advantage of allowing the user to intuitively change the growth rates and discount rates by dragging and dropping the model’s assumptions on the screen (full disclosure required: I am an investor in Insight Guru Inc., the parent company of Trefis, both personally and through the venture capital fund I sub-advise).
Given the complexity of valuation models, it might be tempting to say it’s simply too hard to do. Just trying to get the assumptions right can be daunting. Don’t fall prey to this temptation. Two types of people fail in the investment world: those who just throw up their hands and say valuation can’t be done at all, and those who rely too much on the “false precision” of their models. The best approach is a balance, one which models the cash flows, but remembers that models aren’t foolproof. You can’t worship the model, but you can’t ignore it either.