At this juncture, and after all the thinking, mulling and silent contemplation on the trains and buses, I thought it timely for me to write down my thoughts on valuations and how I approach this slippery topic. With stock markets around the world going into a violent tailspin in the last 8 weeks, perhaps it is also a good time to revisit this topic and to deliberate on exactly how one should think about valuations. The reason for this is that valuations do not exist in a vacuum (unlike what analysts would love for you to believe) and are constantly in flux, changing as often as business conditions change (which is, to say, virtually all the time). Pinning down an exact valuation and projecting it into the future is always difficult, but during volatile and turbulent times this becomes even more of an impossibility. So how should an investor navigate the frigid waters of corporate valuations to find some semblance of dry land? Can he firmly root his feet on the dry sand or will he quickly find out that he is standing, instead, on quicksand?
Valuation as a function of historical corporate profitability (business model approach)
Companies which have been operating for many years (or decades) and which have a track record of steady and growing profitability and stable cash flows should see valuations which are somewhat high as compared to companies which are just starting out and have yet to find their niche. From this standpoint, valuations should be assessed based on a company’s business model and how efficiently it can continue to generate profits and cash flows through good times and bad. As such, recognized blue chips tend to trade at higher valuations even during recessionary periods because of their ability to generate consistent profits throughout all economic cycles, but this has not always been shown to be true.
A conservative and prudent investor should thus assess each company on its own merit, and dissect its business model to see if it is able to function as efficiently through all business cycles. History may not always be able to foretell the future, and there have been numerous cases of companies which had succumbed to new technologies or advances which completed changed the industry landscape and eroded their (seemingly) impenetrable competitive advantage.
Hence, after a review of the business and its underlying prospects and characteristics, one should make a rational assessment of whether it deserves to be accorded high valuations (for a superior and adaptable business model which has a long-lasting impact and can shield the company from the vagaries of the economy), or whether it should be given lower valuations for possible risks (whether perceived or real). This is possibly the most difficult aspect of investing.
Valuation based on economic cycles
Coupled with the above, one should also account for valuations with respect to the stage of the economic cycle. Since the stock market normally precedes the real economy by about six to nine months, it is therefore no easy feat to assign valuations to companies based on economic cycles; but one can use a very rough approximation to cushion for possible error (the proverbial margin of safety so to speak). So let me give a simple illustration:-
As the economy expands and grows, all companies benefit from increased demand for their goods and services, and accordingly these companies will grow, hire staff, expand and earn higher profits and generate better cash flows for their shareholders. Valuations at this stage are thus moderate to high as expectations of growth will rest on a wave of optimism for the future. An investor thus has to temper his expectations of growth in this regard in order not to get carried away on the sea of optimism and hope. Conversely, when the economy is faltering and sputtering and there is trouble left and right (as is the case currently), then valuations would accordingly be much lower as it is expected that companies would suffer from a drop in demand and hence earn lower profits and cash flows. Valuations will therefore be correspondingly lower, and this is something the investor has to accept as part of the economic cycle.
The idea, of course, is to effectively marry the two aspects I mentioned – economic cycles and business characteristics, to be able to determine an approximate level of valuation which is acceptable to the conservative investor. For some companies go into decline, their valuations hit a trough, but they never are able to pick themselves back up and resume their previous growth trajectory. Other companies may prove more resilient and spring back from adversity; thus this underscores the importance of not just financial analysis but also business analysis from a quantitative and qualitative perspective. There is no right or wrong answer, and the investor has to take it upon himself to search for a level of valuation which he feels gives good value and provides adequate justification for his purchase of shares. [Yield does come into the picture, which I will elaborate more on in a separate post.]
Valuation Metrics – Price-Earnings and Price-To-Book
A rather pertinent question one may ask is what kind of valuation metric one should use to determine if valuations are indeed fair, demanding or bargain. The two most common ones which I use and which I feel are relevant to investment decisions are the price-earnings (PE) and Price to Book (PB). PE is essentially how much premium one pays for the earnings of a company, and is the most commonly used metric to gauge valuation. PE can be rather deceiving as it may not apply to all types of companies (e.g. property companies and companies with “lumpy” revenues). Other times, a one-off event may also distort PE and may something look cheap when it is actually expensive. PE should not be used in isolation to weigh valuation but should be used in conjunction with other metrics like ratios as well as yield (also factoring in, of course, the qualitative characteristics of the Company in question).
PB is usually only applicable in cases when earnings are either not stabilized, or when the company has a strong asset base with low earnings. Book value is, very simply, the liquidation value of a company, minus any fire-sale conditions which may result in a haircut discount given to fixed assets and marketable securities. I note that PB is generally used by analysts during protracted bear markets as earnings cannot be reliably predicted during such periods of economic turbulence.
An important note which I have to emphasize (sometimes repeatedly) is that these valuation metrics should not be used in isolation to determine if a company is “cheap”. There are a myriad factors to consider and PE and PB are just two of them. Life (and investing) is certainly much more complex than that!
Relative (Peer-to-Peer) Valuations
One final method I can think of offhand is using peer to peer valuations as a quick rough and dirty method of determining if a Company may be cheap or expensive. Of course, this method is rather rudimentary and requires a lot more in-depth research and refinement, but by itself it should at least offer the investor a glimpse into whether a Company is lagging or leading its competition.
The use of competitors within the same industry ensures that an “apple to apple” comparison can be made. However, one risk of using this apparently simple method is that the industry as a whole may be in decline, thus everything would seem “cheap”. Thus, the conclusion cannot be made using peer valuation in isolation, but should be used in conjunction with Porter’s Five Forces analysis and industry analysis.
Conclusion - how to think about valuations
To conclude, valuations are a rather tricky business as there is no hard and fast rule as to what constitutes cheap or expensive valuations. It depends a lot on not just the economic cycle but also the operating characteristics of the Company in question. During periods of recession and economic slowdown, investors should get used to lower valuations in general, as Mr. Market is feeling pessimistic and is unable to forecast a bright future with much certainty. Investors would then adjust their expectations for future growth accordingly and demand their requisite margin of safety.
Conversely, during periods of economic prosperity (during a boom), valuations will be correspondingly higher; and it is up to the prudent and wary investor to be sceptical of such high valuations and to ensure he is emotionally unaffected by the euphoria and optimism. Of course, this is all easier said than done, but it’s good to have the theoretical foundation as a starting point.